Fraser Forum

Bernanke’s stunning admission and the prospect of another financial crisis

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Former Federal Reserve chairman Ben Bernanke’s recent memoir (The Courage to Act: A Memoir of a Crisis and its Aftermath) offers a stunning admission. He confesses that the Federal Reserve and the Treasury Department were powerless to prevent the Lehman Brothers financial services firm from failing.

“We had no way to save the firm,” he writes. “It was a terrible, almost surreal moment… We were staring into the abyss.” Timothy Geithner, who was to become Treasury Secretary, opined “All we can do is put foam on the runway.”

Later, while testifying to a congressional committee, Bernanke (pictured above) left unchallenged the prevailing view that they had chosen to allow Lehman to go under. Admitting helplessness, he feared, would have spooked markets even further.

The failure of Lehman Brothers is viewed by many as the turning point of the financial crisis. The Federal Reserve and Treasury soon bailed out the U.S. financial sector to the tune of hundreds of billions of dollars. The rescue worked only because it saved everyone. It preserved the financial institutions and saved their insured depositors, and it saved their wholesale depositors (often financial institutions themselves). It also saved holders of their bonds; its derivative counterparties, and even their shareholders—all supposedly sophisticated and informed investors.

The bailouts have left a pernicious residue. The bumper sticker “where’s my bailout?” captures citizens’ bitterness about Wall Street being bailed out while Main Street wasn’t. They also question why the top management of many rescued firms remained in place.

The years since the depths of the crisis have provided policymakers with an opportunity to learn from the experience and bring forward better policies. How have they done?

They have pursued two tacks: one of prevention and one of cure. Prevention tries to make financial institutions safer while cure tries to create ways by which financial institutions can fail safely. They can be traded off against each other: better cure allows less prevention and vice versa.

The push for greater cure seeks to avoid a repeat of the helplessness experienced by Bernanke.  Banking regulators throughout the world have developed resolution plans for dealing with failing financial institutions. They incorporate bail-in provisions whereby bonds are converted to equity as an institution’s condition weakens; they require financial institutions to develop living wills that set out plans for resolution; and they establish timetables for required actions by both the authorities and the troubled institutions.

Placing too much weight on the resolution basket is worrisome. Relying on living wills for winding up an institution seems overly optimistic. Management of going concerns would not be expected to place a high priority on planning for failure while the living will of a failing institution will have been put together by the same management that drove it to the brink. By the time resolution is needed, senior staff needed to implement the plan will have moved on. The resolution plans must be carried out without the opportunity of a practice run: there is no second chance.

Under these conditions, there is a danger the authorities discover they have no way to resolve failing institutions without resorting to extensive bailouts.

But a bigger danger lies in the trade-off between prevention and cure. Overconfidence in resolution may lead policymakers to settle for less prevention. Simply put, a greater emphasis on prevention is needed to avoid another financial crisis.

This greater emphasis does not mean the heavy-handed Dodd-Frank approach adopted in the U.S. Already hordes of lawyers are poring over the thousands of pages of resulting regulations, seeking ways to allow financial institutions to do what they want.

Research shows that reliance on simple leverage ratios (the ratio between an institution’s borrowing and its shareholders’ contribution) and capital ratios (the size of the buffer between an institution’s liabilities and its assets) is better able to limit the risk that institutions undertake.

This same research suggests that leverage ratios of major international banks still remain too high—and their capital ratios remain too low—to prevent a repeat of the financial crisis.


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