Bernanke’s ‘Systemically Important’ Question

On March 10, 2009, Ben Bernanke delivered a professorial speech on the principles the Federal Reserve should follow in trying to avoid another mess of a financial crisis. I sent a link to the speech to a good friend of mine who is about as bright a guy as there is out there. His reply: “My eyes glazed over.”

The speech is not a fun read. Bernanke floats certain ideas, without taking a stand on them. For example, he says “policymakers should consider” charging bankers more for deposit insurance when times are good, so that the system is protected when times are, well, like they are now. Why Bernanke doesn’t take more of a forceful stand on something so obvious, I am not sure.

But that is not what I write about today. I want to address a presumption he makes in the speech that I am not sure is true, or at least has not been proven true by the chairman of the Fed. That is this notion that there are “systemically important financial institutions.”

The basic presumption of Bernanke’s platform is that steps should be made to trim systemic risk in the economy. Systemically important financial institutions, however, must be protected and maintained.

In a crisis, the authorities have strong incentives to prevent the failure of a large, highly interconnected financial firm, because of the risks such a failure would pose to the financial system and the broader economy.

But in the same paragraph, Bernanke states that the mere presence of such a firm is bad.

However, the belief of market participants that a particular firm is considered too big to fail has many undesirable effects. For instance, it reduces market discipline and encourages excessive risk-taking by the firm. It also provides an artificial incentive for firms to grow, in order to be perceived as too big to fail. And it creates an unlevel playing field with smaller firms, which may not be regarded as having implicit government support. Moreover, government rescues of too-big-to-fail firms can be costly to taxpayers, as we have seen recently. Indeed, in the present crisis, the too-big-to-fail issue has emerged as an enormous problem.

You would think after stating the obvious, Bernanke would go that next step to say that firms with overbearing risk to the US economy should be eliminated (or in fact subdued). But he does not.

In the midst of this crisis, given the highly fragile state of financial markets and the global economy, government assistance to avoid the failures of major financial institutions has been necessary to avoid a further serious destabilization of the financial system, and our commitment to avoiding such a failure remains firm.

Essentially, he advocates for the continuing presence of systemically important financial institutions, and he favors their protection. This is how the whole “systemic risk regulator” came up. He would rather employ another regulator than just avoid the problem altogether. I have a tough time seeing this position as anything but capitulation.

Neither Bernanke, the Fed, nor the Treasury has offered any tangible definition of what is a systemically important financial institution or even systemic risk. (As readers of this blog know, Boaz Salik and I have recently offered definitions of both.) The closest the federal government has gotten to defining a systemically important financial institution is in its January 21, 2009, Guidelines for Systemically Significant Failing Institutions Program. Here is how the litmus test Treasury uses to define such a firm:

1. The extent to which the failure of an institution could threaten the viability of its creditors and counterparties because of their direct exposures to the institution;

2. The number and size of financial institutions that are seen by investors or counterparties as similarly situated to the failing institution, or that would otherwise be likely to experience indirect contagion effects from the failure of the institution;

3. Whether the institution is sufficiently important to the nation’s financial and economic system that a disorderly failure would, with a high probability, cause major disruptions to credit markets or payments and settlement systems, seriously destabilize key asset prices, significantly increase uncertainty or losses of confidence thereby materially weakening overall economic performance; or

4. The extent and probability of the institution’s ability to access alternative sources of capital and liquidity, whether from the private sector or other sources of government funds.

Each of these criteria is subjective. The viability of how many creditors’ and counterparties’ are threatened? What degree of contagion? What is the definition of “contagion”? What does “disorderly failure” mean to the Treasury? What is the threshold of illiquidity? Is it a “you know it when you see it” threshold?

Bernanke was stung by Lehman Brothers Inc. He let it fail and it caused a calamity. As a result, he categories Lehman as a systemically important financial institution, and that’s that. But why? Why is it that the only alternative Bernanke offers is to maintain the status quo on too-risky institutions? He certainly has offered no proof for why he adheres to this position.

Just as the nation cured itself of the ills of monopolies, so too can the US cure itself of the ills of systemic risk. I do not believe that we need financial institutions of a certain size in order to run our economy. This is the same argument made about monopolies during the late 1800s. The services provided by mega financial firms can and will be redistributed across the economy. That’s how economics works. Ben Bernanke should know that.

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