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"Too Big To Fail" - A Year Later

Sunday, September 13, 2009

Last September, financial markets were on the brink of collapse. After Lehman Brothers filed for bankruptcy, panic and havoc engulfed Wall Street. Lending consequently came to a near standstill, and we entered a period of financial tumult unseen since the Great Depression. Indeed, with the specter of a fallen Lehman looming over regulators, a verdict was rendered: “Some institutions are just too big to fail.” Thus, the government stepped in to mitigate the situation and to prevent further failures by authorizing the $700 billion Troubled Assets Relief Program.

A year after, top financial experts are feeling cautious but optimistic. Last month, Ben Bernanke, the Chairman of the Federal Reserve remarked: “The prospects for a return to growth in the near term appear good.”

Moreover, the Department of the Treasury has allowed certain measures expire now that the economy has improved and their need has diminished. Specifically, at the end of this month, the Treasury’s guarantee program for money markets mutual funds will terminate. Likewise, while still in effect, use of liquidity providing tools such as the Commercial Paper Funding Facility (CPFF) and the Term Auction Facility (TAF) has decreased by 87 percent, and 57 percent respectively.

In his testimony before the Congressional Oversight Panel, however, US Treasury Secretary Timothy Geithner cautioned that “it would not be appropriate or prudent for us to infer from that sign of progress that we're at the point where we can start to walk this stuff back, wind it back completely.”

The implicit government guarantees though need to be unraveled slowly to protect the taxpayer and to prevent financial firms from indulging in excessive risk-taking. Of course, as the Economist rightly noted, “Government bailouts have also prevented the [finance] industry from shrinking as much as it might have.” Thus, the Treasury should demand and adequate return on its initial investment in these firms, particularly those injected through the Capital Purchase Program. Furthermore, although regulation can ensure that firms meet capital adequacy standards, Wall Street has proven quite resourceful in experimenting with new financial tools (see Lucas Puente’s post on life settlements). Large banks must impose self-discipline – a characteristic that has sorely been missing in the dealings of these corporations. And this will only be borne if the government refuses past a certain point to prop up “too-big-to-fail” firms.

While policymakers have acknowledged the need to plan “exit strategies,” no significant recommendations have emerged. Instead, writing in the Financial Times, before the G-20 finance ministers’ meeting last week, Geithner emphasized the importance of “strengthening capital requirements as an essential part of a broader effort to modernize our regulatory framework.” One cannot dispute the need for this strategy along with greater transparency throughout the industry. But it is also incumbent upon this administration to refuse support to those organizations that do not “live within their means". In other words, what is true for the American consumer should also be true for the American firm.

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