No Bank “Too Big To Fail”

Kevin Warsh of the Federal Reserve warns that by bailing out banks, government has only strengthened moral hazard in the financial sector.

In a speech delivered before the New York Association for Business Economics in New York City on February 3, Governor Kevin Warsh of the Federal Reserve declared that it is “a time for choosing” for the US economy. “Efficacy,” said Warsh, “not convenience, should be the foremost goal of policymakers.”

The youngest member of the Federal Reserve’s board of governors pointed out that a “broader understanding of what occurred” is required before any effective reform can be passed. Where his boss continues to cite “regulatory failure” when pressed on the causes of the recession, Warsh referred to “a multitude of flawed private and public practices.” Specifically, the so-called government-sponsored enterprises Fannie Mae and Freddie Mac “were given license and direction to take excessive risks,” according to Warsh.

The private sector is not free of blame, said Warsh, and he believes that “the financial architecture requires additional reforms to mitigate the too-big-to-fail problem.” No bank, he stressed, should be “too big to fail.” “The growing specter of government support threatens to weaken market discipline, confuse price signals, and create a class of institutions that operate under different rules of the game. This state,” he warned, “is not acceptable.”

To address the problem, Warsh sees a number of options: First, the sharing of information. “Stakeholders can then make better informed judgments of potential risks and rewards.” Second, more robust competition. “Market entry and market exit can be a more effective means of developing a stronger, more resilient financial system.”

Competition is undermined when a privileged class of financial firms has the implicit support of the government. No firm ought to be entitled to favored consideration by regulators or government policy.

Lastly, Warsh favors stronger capital and liquidity buffers as well as “more rigorous risk-management practices” to operate as safeguards. “Simplifying corporate forms and structures so firms can quickly be unwound, particularly across borders, would be a welcome development.”

The current trend toward Washington “micromanagement” of banks is a dangerous development, said Warsh; one that “can harm an economy that desperately needs a competitive, vibrant, sustainable banking system.” Indeed, the whole of the US economy “runs grave risks if we slouch toward a quasi-public utility model.”

I worry that some systemically significant firms may end up willing to accept new, permanent government masters and supplementary public purposes in order to protect their status. Apportioning economic rents to appease the official sector may appear rational to some firms. But, it is destructive to the financial and economic system overall. We should not want clients of the state at the core of our financial system. We do not want some new social contract between government and large banks. Now more than ever, we need more private firms competing to serve client needs and make markets.

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