If Barack Obama Could Achieve Only One Financial Reform, What Should It Be?

Restore the Ability to Fail

President Obama should recognize that in its ninety-five-year history, the Federal Reserve has never announced or implemented a lender-of-last resort policy. And it hardly ever, almost never, allows a large bank or financial firm to fail. When it rashly changed this policy for Lehman Brothers, it created great uncertainty. In this era of rational expectations, this is the opposite of good policymaking.

Capitalism without failure is like religion without sin.

One part of its new policy should extend FDICIA (the Federal Deposit Insurance Corporation Improvement Act of 1991) to all financial firms, another should require the Federal Reserve to implement FDICIA, and a third should declare that "too big to fail" is too big. "Too big to fail" encourages excessive risk taking with losses going to the taxpayers. Capitalism without failure is like religion without sin; it doesn’t work.

Allan H. Meltzer is a visiting scholar at AEI.


Adopt the Swedish "Good Bank/Bad Bank" Approach

Rebuilding the credibility of the U.S. financial system will be a Herculean task and seeking a single regulatory reform to do so would be a fool's errand. For the present, deep lack of credibility is not so much an issue of regulatory inadequacy. Rather it is one of a lack of solvency of many important financial institutions and a lack of transparency that makes it difficult to ascertain the severity of that insolvency.

My advice to President Obama would be to make a clean break from the failed policies of the previous Administration that treated the financial sector crisis more as a liquidity problem rather than as a solvency problem. The overarching objective of financial sector policy must be to quickly distinguish between solvent institutions, which should be supported, and insolvent institutions, which should be forcibly restructured. In implementing such a policy, the Administration would be well advised to adopt the Swedish "good bank/bad bank" approach to the problem rather than to go down the failed Japanese route of the 1990s. The Administration would also be advised to refrain from pretending that bank restructuring can be done on the cheap.

The Administration would also be advised to refrain from pretending that bank restructuring can be done on the cheap.

I would also caution President Obama not to expect too much from regulatory reform, especially if we are to have a financial system that continues to be dominated by a small number of institutions that are too big to fail. I would propose that he take advantage of the present financial sector crisis to create a more competitive banking system by breaking into smaller pieces those large banks that need to be forcibly reorganized.

Desmond Lachman is a resident fellow at AEI.

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