In the spring of 2009 I received a prescient message from Philip Wellons, who had recently retired from Harvard Law School, where he had been deputy director at the Program on International Financial Systems. He correctly saw that new legislation would be required to facilitate an orderly resolution of insolvent but inter connected financial firms other than commercial banks:

On financial regulation: we need to improve the regulatory structure. I would like to see a comprehensive approach across financial markets, including insurance. We can’t simply go back to reliance on capital adequacy regulation. Too many of us can’t gauge risk well—Basel II was a complex mess built on rating agencies. But I don’t see shifting to general principles as the alternative—they only work with homogeneous populations (think Bank of England and London 40 years ago), and world finance is diverse. I don’t see us going back to the 1980s’ idea of segregating (and thoroughly regulating) the deposit takers, while freeing all other financial activities. Now non-deposit takers, and relations among all financial entities, are too large and complex. I end up thinking we need to address the “too big” part of “too big to fail.” Go after the big guys with scalpels and cleavers. Insure deposits and some other liabilities, but let the weak fail.

People who accept the need for deposit insurance and special regulation and supervision for banks have a conceptual disconnect now. They said in the past that we treat deposit-taking banks as special because politics will force the government to bail the banks out to forestall runs. Now it looks as though the collapse of certain non-banks could also bring the financial system to its knees. It was the complexity of Lehman…s counterparty relationships that scared people, raising the worries about systemic effects … The threat last fall was not the same as a run on banks because last fall no one knew what each contract gave counterparties in a default. The fear is that the consequences would be at least as devastating as a bank run.

The game changed when U.S. government bailed out non-banks. Now that we all know politicians will step in, financial regulators better anticipate and try to reduce the potential exposure over non-banks, as regulators now do with deposit takers … The genie is out of the bottle. S/he ran off with the cow as it left the barn.¹

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© 2016 David E. Lindsey

Policies and ethics