Ben Bernake's Wishlist For Financial Reform

Ben Bernanke says that the existence of very large financial firms are necessary in the global economy although government must be allowed to unwind failing firms without causing disruption to the system and costing taxpayers. He also calls for limits on excessive risk taking and a level playing field that allows for smaller banks to compete. See the following post from Economist's View.

In a speech today, Ben Bernanke says the financial system is far from the "competitive ideal," and that the too-big-to-fail problem is the primary cause of the "insidious barriers to competition" and "competitive inequities" that currently exist in these markets.

One thing I'd add is that there is reason to be concerned about the size of these firms over and above the too-big-to-fail problem, i.e. for traditional reasons involving the exercise of market power. Bernanke says that:

our technologically sophisticated and globalized economy will still need large, complex, and internationally active financial firms to meet the needs of multinational firms, to facilitate international flows of goods and capital, and to take advantage of economies of scale and scope

But I'd like to have more precise information about how large these firms need to be until the economies of scope and scale begin bottoming out. If it's so large that firms can gain a substantial market share by moving down the cost curve, then regulators need to ensure that firms do not exploit their market power:

...Toward a More Competitive, Efficient, and Innovative Financial System The United States has a financial system that is remarkably multifaceted and diverse. Some countries rely heavily on a few large banks to provide credit and financial services; our system, in contrast, includes financial institutions of all sizes, with a wide range of charters and missions. We also rely more than any other country on an array of specialized financial markets to allocate credit and help diversify risks. Our system is complex, but I think that for the most part its variety is an important strength. We have many, many ways to connect borrowers and savers in the United States, and directing saving to the most productive channels is an essential prerequisite to a successful economy.

That said, for the financial system to do its job well, it must be an impartial and efficient arbiter of credit flows. In a market economy, that result is best achieved through open competition on a level playing field, a framework that provides choices to consumers and borrowers and gives the most innovative and efficient firms the chance to succeed and grow. Unfortunately, our financial system today falls substantially short of that competitive ideal.

Among the most serious and most insidious barriers to competition in financial services is the too-big-to-fail problem. Like all of you, I remember well the frightening weeks in the fall of 2008, when the failure or near-failure of several large, complex, and interconnected firms shook the financial markets and our economy to their foundations. ... It is unconscionable that the fate of the world economy should be so closely tied to the fortunes of a relatively small number of giant financial firms. If we achieve nothing else in the wake of the crisis, we must ensure that we never again face such a situation.

The costs to all of us of having firms deemed too big to fail were stunningly evident during the days in which the financial system teetered near collapse. But the existence of too-big-to-fail firms also imposes heavy costs on our financial system even in more placid times. Perhaps most important, if a firm is publicly perceived as too big, or interconnected, or systemically critical for the authorities to permit its failure, its creditors and counterparties have less incentive to evaluate the quality of the firm's business model, its management, and its risk-taking behavior. As a result, such firms face limited market discipline, allowing them to obtain funding on better terms than the quality or riskiness of their business would merit and giving them incentives to take on excessive risks.

Having institutions that are too big to fail also creates competitive inequities that may prevent our most productive and innovative firms from prospering. In an environment of fair competition, smaller firms should have a chance to outperform larger companies. By the same token, firms that do not make the grade should exit, freeing up resources for other uses. Our economy is not static, and our banking system should not be static either.

In short, to have a competitive, vital, and innovative financial system in which market discipline encourages efficiency and controls risk, including risks to the system as a whole, we have to end the too-big-to-fail problem once and for all. But how can that be done? Some proposals have been made to limit the scope and activities of financial institutions, and I think a number of those ideas are worth careful consideration. Certainly, supervisors should be empowered to limit the involvement of firms in inappropriately risky activities. But even if such proposals are implemented, our technologically sophisticated and globalized economy will still need large, complex, and internationally active financial firms to meet the needs of multinational firms, to facilitate international flows of goods and capital, and to take advantage of economies of scale and scope. The unavoidable challenge is to make sure that size, complexity, and interconnectedness do not insulate such firms from market discipline, potentially making them ticking time bombs inside our financial system.

To address the too-big-to-fail problem, the Federal Reserve favors a three-part approach.

First, we and our colleagues at other supervisory agencies must continue to develop and implement significantly tougher rules and oversight that serve to reduce the risks that large, complex firms present to the financial system. Events of the past several years clearly demonstrate that all large, complex financial institutions, not just bank holding companies, must be subject to strong regulation and consolidated supervision. Moreover, the crisis has shown that supervisors must take account of potential risks to the financial system as a whole, and not just those to individual firms in isolation. Implementing supervision in a way that seeks to identify systemic risks as well as risks to individual institutions is a difficult challenge, but the fact is that the traditional approach of focusing narrowly on individual firms did not succeed in preventing this crisis and likely would not succeed in the future. ...

The second component of the strategy to end too-big-to-fail is to increase the resilience of the financial system itself, to reduce the potential damage from a systemic event like the failure of a major firm. ... Limiting the fallout from the failure of a major firm is not only directly beneficial in a crisis, it also helps to reduce the too-big-to-fail problem, because the government has much less reason to intervene if it believes that the financial system is resilient enough to handle a significant failure without excessive disruption.

Third, because government oversight alone will never be sufficient to anticipate all risks, increasing market discipline is an essential piece of any strategy for combating too-big-to-fail. To create real market discipline for the largest firms, market participants must be convinced that if one of these firms is unable to meet its obligations, its shareholders, creditors, and counterparties will not be protected from losses by government action. To make such a threat credible, we need a new legal framework that will allow the government to wind down a failing, systemically critical firm without doing serious damage to the broader financial system. In other words, we need an alternative for resolving failing firms that is neither a disorderly bankruptcy nor a bailout. ... If, in the end, funds must be injected to resolve a systemically critical institution safely, the ultimate cost must not fall on taxpayers or small financial institutions, but on those institutions that are the source of the too-big-to-fail problem.

I don't want to understate the difficulties of creating an effective resolution framework for large, interconnected firms. Such firms can be extraordinarily complex, both in terms of their legal structure and in the range and sophistication of their activities. The resolution of large institutions whose operations span many countries poses particular challenges, as legal frameworks vary across countries, and the authorities in each country naturally seek to protect the interests of depositors and creditors in their own jurisdictions. We must also recognize that such resolutions might well take place in the context of a broader crisis, in which the government might be forced to address problems at multiple firms simultaneously. Careful planning is therefore essential. An idea worth exploring is to require firms to develop and maintain a so-called living will, which will help firms and regulators identify ways to simplify and untangle the firm before a crisis occurs. ...

This article has been republished from Mark Thoma's blog, Economist's View.