Who's Too Big to Fail? - Regulators today won't define 'systemic risk,' unlike 25 years ago

Who's Too Big to Fail? WSJ Editorial
Regulators today won't define 'systemic risk,' unlike 25 years ago.
WSJ, Sep 14, 2009

With Congress back in session and the anniversary of the Lehman Brothers failure upon us, the Obama Administration is resuming its quest for greatly expanded authority to bail out American businesses. Under the Treasury reform blueprint, any financial company, whether a regulated bank or not, could be rescued or seized by the Federal Deposit Insurance Corporation if regulators believe it poses a systemic risk.

If recent history is any guide, when the feds stage their next intervention, they will not define "systemic risk" and they will refuse to release the data underlying their decision. To this day, taxpayers can only guess at the specific reasons behind the ad hoc rescues that began with Bear Stearns in March of 2008. Now Team Obama seeks to codify the bailout policies of the last 18 months.

Before receiving authority for new adventures across U.S. commerce, financial regulators should explain their current interventions. The basic questions: How exactly does the government measure systemic risk, and how do regulators know that the U.S. economy can't live without a particular firm? Americans still don't know why Bear, Citigroup and AIG were saved, but Lehman wasn't.

A recently-filed federal lawsuit seeks answers. Plaintiff Vern McKinley worked at the FDIC in the 1980s and is now suing his old employer, as well as the Federal Reserve. The two agencies have been stiff-arming his Freedom of Information Act requests on last year's bailouts.

Last December, Mr. McKinley sent a FOIA request to the Fed to find out what Fed governors meant when they said a Bear Stearns failure would cause a "contagion." This term was used in the publicly-released minutes of the Fed meeting at which the central bank discussed plans by the Federal Reserve Bank of New York to finance Bear's sale to J.P. Morgan Chase. The minutes contained only the vague warning of doom, without any detail on how exactly the fall of Bear would destroy America. Mr. McKinley's request sought the supporting documents for this conclusion.

He also requested minutes of the autumn FDIC board meeting at which regulators approved financing for a Citigroup takeover of Wachovia. To provide this assistance, the board had to invoke the "systemic risk" exception in the Federal Deposit Insurance Act, and therefore had to assert that such assistance was necessary for the health of the financial system. Yet days later, Wachovia cut a better deal to sell itself to Wells Fargo, instead of Citi. So how necessary was the FDIC's offer of assistance?

After Mr. McKinley sued the agency this summer, the FDIC coughed up a previously undisclosed staff memo to the FDIC board. Again, the agency redacted the substance, providing roughly two pages of text from the nine-page original. The section of the memo titled "Systemic Risk" was entirely erased. As for the Fed, it blew off Mr. McKinely's initial request and has since responded mainly with some highly uninformative letters from the Fed staff to Congress.

For rescues of institutions deemed "too big to fail," this lack of disclosure is striking. Twenty-five years ago this month, Congress began hearings on Continental Illinois National Bank and Trust, which had received a government rescue of creditors and uninsured depositors just four months earlier. Rather than vague warnings of "severe" consequences for "fragile" markets offered by Bush and Obama regulators, the public received detailed information on Continental Illinois and its relation to other institutions.

By early October, the alleged "systemic risk" was being defined—and debated—very precisely. The FDIC held that 179 smaller banks would have been at high risk of failure due to their Continental Illinois exposures if the bank had been allowed to collapse. Combing through the data, the staff of the House Banking Committee and the General Accounting Office countered that only 28 banks would have been at high risk.

In contrast, the counterparties that benefited from the AIG bailout last year were only formally disclosed in 2009 after months of public pressure and after the Journal's reporting had already revealed most of the details. A public debate on which banks really needed a bailout via the government's AIG conduit has hardly taken place. And did all of Bear Stearns' creditors, including hedge funds, need to be made whole to ensure the survival of American capitalism?

A year after the epic meltdown, this is the debate Congress needs to undertake before legislating any new federal authority. Regulators should not receive a blank check to prevent systemic risk without even defining what that term means.