How to Watch the Banks

By Henry M. Paulson, Jr.

SIXTEEN months ago, our financial system teetered on the brink of collapse. The Treasury, the Federal Reserve and the Federal Deposit Insurance Corporation took actions that were unpopular and previously unthinkable — but absolutely necessary to stave off an economic catastrophe in which unemployment could have exceeded the 25 percent level of the Great Depression.

These temporary actions have ended or will end. And our financial system is much more stable. But it is critical that we learn from the financial crisis and put in place reforms to avert a repeat of 2008 or something even worse.

Congress must pass financial regulatory reform. Delays are creating uncertainty, undermining the ability of financial institutions to increase lending to the businesses of all sizes that want to invest and fuel our recovery. Our overriding goal in restructuring our financial architecture should be that taxpayers never again have to save a failing financial institution.

The debate recently has centered on big banks and trading risks. I agree that big banks do pose a dangerously large risk to our financial system, and I am troubled that concentration in the industry has only increased since the crisis. But if we are to protect our system from falling into trouble again, we need broad-based reform that covers all types of financial institutions and all forms of potentially risky activities.

For example, the most recent proposal by the Obama administration — to bar big banks from trading driven by other than customer-related activity — would not have prevented the collapse of Fannie Mae, Freddie Mac, Lehman Brothers, American International Group, Washington Mutual, Wachovia or other institutions whose failure contributed to the crisis. Rather than dictating a set of rules that will become out of date as the markets evolve, policy makers should devise legislation that ensures that regulators have the authority to tackle the issue of size and all potential systemic risks.

This calls for two vital changes. First, we must create a systemic risk regulator to monitor the stability of the markets and to restrain or end any activity at any financial firm that threatens the broader market. Second, the government must have resolution authority to impose an orderly liquidation on any failing financial institution to minimize its impact on the rest of the system.

Together, these two reforms will enable the regulatory system to better prevent the kinds of excesses that fueled our recent crisis, restore market discipline and keep the failure of a large institution from bringing down the rest of the system.

A single agency responsible for systemic risk would be accountable in a way that no regulator was in the run-up to the 2008 crisis. With access to all necessary information to monitor the markets, this regulator would have a better chance of identifying and limiting the impact of future speculative bubbles.

Given our global markets, we have to address the issue of size on a multinational level. We should work through the Financial Stability Board, a global regulatory agency with headquarters in Switzerland, to establish an international agreement calling for stronger capital and liquidity requirements for large, complex institutions. The need for adequate liquidity cushions is not as well understood, but in my judgment it is even more important than the need for banks to maintain higher capital levels.

As for our domestic approach, we now have different government regulators focusing on the individual trees, and we need one regulator accountable for looking at the entire forest. My preference is for the Federal Reserve to be the systemic risk regulator, because the responsibility for identifying and limiting potential problems is a natural complement to its role in monetary policy.

Congress, however, seems to be moving toward having a council of regulators perform this function. While that is not my preference, I believe a council can be workable if it is led by either the Treasury secretary or the Fed chairman, and is structured to ensure that strong decisions are reached quickly in a crisis. Too many such panels in government act by consensus, allowing a single member to render the council immobile.

No systemic risk regulator, no matter how powerful, can be relied on to see everything and prevent future problems. That’s why our regulatory system must reinforce the responsibility of lenders, investors, borrowers and all market participants to analyze risk and make informed decisions. This is possible only if everyone understands that no financial institution is too big to fail, and that its investors and creditors will have to bear the consequences if it does. 

To address the moral hazard issue, the government needs broad-based authority to liquidate any failing financial institution without going through the bankruptcy process, which is not well-suited for such complex firms in the midst of a financial crisis. We must send a clear signal to market participants that whenever this process is put in motion, the outcome is liquidation; we cannot leave any hope that we would inject taxpayer dollars to preserve the failing firm in its present form.

Winding down a large institution is difficult and time-consuming. The regulators with this responsibility will need to be trained to do the job. And we must also require all large firms to develop a road map for their liquidation well ahead of any failure.These are not the only necessary reforms — we must also address regulation of derivatives and our over-reliance on credit ratings agencies.

Over time, we have to simplify the patchwork quilt of regulatory agencies and improve transparency so that consumers and investors can punish excesses through their own informed investing decisions. We have to examine the many policies that favor homeownership, and recalibrate our support for them. We must also tackle what is by far our greatest economic challenge — the reduction of budget deficits — a big part of which will involve reforming our major entitlement programs: Medicare, Medicaid and Social Security.

It has been a difficult, and humbling, two years for our nation. But every other major country has more significant economic problems than we do and, with the resilience of our economy and the ingenuity of our people, we can meet our challenges. Nonetheless, we must not lose our sense of urgency, or the political courage to make the necessary reforms to ensure our long-term prosperity.

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