As the Obama administration reveals its plans for overhauling financial regulation, one question it has never answered squarely is just why Washington has been so concerned, over the last two years, with bailing out large financial institutions.

In August 2007, the U.S. Federal Reserve saw the chaos triggered by the bursting of the housing bubble as a liquidity crisis -- essentially a matter of banks mistrusting one another because of the unknown quantities of dubious assets on their books. So the Fed poured additional liquidity into the system to prevent contagion.

By March 2008, it became clear that the problem was not just liquidity, but solvency. So the U.S. Treasury decided to rescue the troubled investment bank Bear Stearns, forcing it into a shotgun marriage with JPMorgan Chase and providing an extraordinary $30 billion dowry from taxpayers to lubricate the deal.

Then, during the summer of 2008, new threats emerged as two other organizations deemed "too big to fail" veered toward collapse: Fannie Mae and Freddie Mac, the two giant mortgage companies that are "government-sponsored enterprises" with private-sector shareholders. In September, the Treasury felt compelled to step in and rescue them as well.

Soon afterward, to avoid looking like an easy touch, government officials allowed Lehman Brothers to be forced into bankruptcy, but the market reaction to that was so bad that they immediately reversed course, rescuing American Insurance Group with a combination of Treasury and Fed resources and asking Congress to approve a $700 billion Troubled Asset Relief Program. Then Treasury Secretary Henry Paulson initially planned to use the money to buy toxic assets from financial institutions. But that approach ran afoul of political pressures to avoid doing favors for financiers, so Paulson switched tactics and began to provide capital infusions to the financial institutions directly (in order to offset their financial losses on mortgage-backed securities, collateralized debt obligations, and other troubled holdings).

The Federal Reserve, meanwhile, introduced new mechanisms to buy financial assets in the marketplace. With the Term Asset-Backed Securities Loan Facility (TALF) -- the Fed's effort to resuscitate a functioning securitization market -- direct public-sector support for the private financial system will be extended to commercial real estate-related securities, securitized small-business loans, and whatever else the Fed chooses. The Federal Deposit Insurance Corporation, finally, has extended its guarantees of small bank deposits to nearly all bank deposits as well as bond issues of depositary institutions.

All this adds up to unprecedented trillions of dollars of public support for the financial system, an intervention that has generated substantial criticism. Many observers would have preferred to let big banks and financial institutions in trouble fail and be forced to restructure. Other critics accepted the principle of rescue, on the grounds that laissez-faire alternatives would have even worse consequences, but argued for full-fledged nationalization; since the government was going to be responsible for keeping the troubled firms in business, they reasoned, why not take the firms over directly? Even those who generally accept the actions of the semi-divine trinity -- first Paulson-Bernanke-Geithner, and now Bernanke-Geithner-Summers -- resolved to make sure that nothing like this could happen again by pressing for  cutting the banks down to manageable size and barring them from using excessive leverage.

Critics of the bailouts have raised a number of valid points that policymakers have so far shied away from confronting directly. Usually, such behavior means critics are right. But in this case, it doesn't. There are actually several good arguments for why the government's stepping in to preserve large private banks is a good idea -- but few officials have made them, most likely because they think the public wouldn't find the reasoning persuasive enough to justify spending such vast sums and mortgaging the country's future.

1. Big banks finance risk-takers. The U.S. economy needs risk-takers to provide financial services to the majority of citizens and businesses who are risk averse. For example, retirees who want to protect against a sharp downturn in the stock market using put options (contracts in which the buyer acquires the right to sell a financial instrument later at a predetermined price) need financial institutions able to sell them. And a U.S. architectural firm bidding, say, for the right to build a new shopping mall in Brazil, yet unversed in foreign currency risks, needs to be able to rely on a bank or other financial institution with the size, experience, and foreign connections to minimize those risks. Risk-takers such as hedge funds play an instrumental role in all this, and banks need to be large in order to accumulate the talent and facilities necessary to finance them. Small and medium-sized banks have tried but simply cannot do it.

2. Big banks finance deals, especially big ones. Large-scale mergers and acquisitions, as well as transactions involving private equity funds, normally require financing packages that are arranged in advance with complete secrecy. Moreover, even simply advising one side or the other in a big M&A transaction requires an immense array of expertise in a variety of disciplines: legal, regulatory, accounting, government relations, and media relations. Big banks that have been traditionally active in this area have these skills or know how to retain them.

3. Big banks can trade in size in global capital markets. Small and medium-sized banks cannot keep up with the large scale and quick tempo of international capital markets. Only large banking institutions can maintain ongoing relationships with giant counterparties including multinational corporations, central banks or other government agencies, and sovereign wealth funds. With the United States running chronic balance-of-payments deficits, it is in the national interest to have banks large enough to maintain such relationships in order to facilitate large capital inflows.

4. Big banks are in the derivatives business, small and medium-sized institutions are not. Admittedly, this does not sound like a recommendation, given how many large financial institutions have gotten in trouble recently through mismanagement of their derivatives units. But derivatives are not going away -- credit default swaps, for instance, offer immense benefits to users because they vastly reduce the cost of managing portfolios of corporate bonds, mortgage-backed securities, and other securitized instruments. In the future, counterparty risk will be taken far more seriously, which will mean more in-depth vetting of trading partners. This process is often possible only with big institutions, because it takes highly trained specialists to pore over the numbers and ask the right questions about the financial health of major counterparties.

5. Big banks run big IT operations. There are immense economies of scale in niches such as corporate cash management, credit-card back office, mortgage servicing, securities custody, and performance attribution. They will not disappear. Studies that seem to show a lack of economies of scale in banking are not wrong, just badly designed. Although there are not many economies of scale in credit analysis, only a handful of large banks with global reach can perform highly computerized back-office servicing functions.

The above points explain why financial institutions grew so large and why that was and remains a generally good thing for the economy as a whole. But what about arguments that the government should never again allow such firms to grow "too big to fail"?

There are indeed problems with massive bailouts, particularly the danger that they will create "moral hazard" -- an incentive for institutions to behave recklessly in the future on the assumption that the government will bear the losses if anything goes wrong. But the appropriate way to prevent such behavior is not to limit the size of financial institutions, but rather to reform their corporate governance.

Board members of banks have been treated more strictly than board members of other corporations since 1991, when the Federal Deposit Insurance Corporation Improvement Act was passed to overcome the abuses that led to the savings and loan crisis of the 1980s. For example, members of boards of depository institutions are limited in the number of boards they can serve on, and they must accept personal liability for the decisions of a failed institution. Since then, the system has worked reasonably well for smaller banks (but not for larger institutions, where most board members are simply ill-equipped to stay on top of the immense amount of detail involved)..

Further improving board oversight of bank management must be a top priority in any attempt to construct a safer and sounder financial system. The current category of independent directors, which brings to the boardroom people of diverse backgrounds and business experience, is not necessarily bad. But it is not enough. There should be a second kind of independent board member, as well -- essentially, a category of "professional directors" -- who are elected directly by shareholders. These directors would chair the three most important board committees -- audit, risk management, and compensation.

Such a reform could materially strengthen the ability of banks and other important financial institutions to move ahead without stumbling into new risks. That is because professional directors -- unlike even well-intentioned amateur ones -- would have both the skills and incentive to execute their duties with a high level of care. If they performed haphazardly or casually, they would risk losing the stature necessary to continue to serve on boards of other companies. Their livelihoods would depend, in other words, on their willingness to understand exactly what a bank is doing, what risks it is taking, and how proficient top management is in running a complex business.

Whatever else the Obama administration focuses on in its regulatory reforms, it should not waste time or effort trying to limit financial institutions' size. Responsible board oversight and governance is much more important.


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  • ROGER M. KUBARYCH is Chief U.S. Economist at Unicredit Global Research and Henry Kaufman Adjunct Senior Fellow for International Economics and Finance at the Council on Foreign Relations.
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