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The Obama administration and Congress are nowfilling in the details of a long-anticipated plan forreorganizing and restructuring financial regulation.It is no exaggeration to say that the proposal willcreate what are essentially government-sponsoredenterprises (GSEs) like Fannie Mae and FreddieMac in every sector of the financial economy.The principal elements of the administration’splan are these:•Establishing a federal agency as the systemicregulator of the financial system•Giving that agency the authority to desig-nate “systemically important” financial insti-tutions and establish a special regulatorystructure for these firms•Providing a mechanism for the governmentto take control of financial institutions whenand if it decides that their failure will create“systemic risk”Tobe sure, there are differences between theimplicit government backing that Fannie and Fred-die exploited and a designation as a “systemicallyimportant” firm, but in competitive terms, these dif-ferences are minor.Designation as a systemicallyimportant firm is, in effect, a certification by thegovernment that a firm is too big to fail—its failure,in theory, will create systemic risk—and this statuswill be seen in the markets as lowering its risk asaborrower.Lower risk will translate into lower
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1150 Seventeenth Street, N.W., Washington, D.C. 20036202.862.5800www.aei.org
Reinventing GSEs: Treasury’s Plan for Financial Restructuring
By Peter J. Wallison
In late March—timed to impress the G20—the Obama administration revealed its plan for regulating and restruc-turing the U.S. financial system. There were no surprises; its approach, presented by Treasury Secretary TimothyGeithner, endorsed both a single powerful systemic regulator, with authority to designate and regulate “systemicallyimportant” institutions in every financial sector, and a system for liquidating or bailing out financial firms that mightcause a systemic breakdown if they failed. Although presented as a way to prevent a repeat of the current financialcrisis, the proposals will, if implemented, seriously impair competitive conditions in all U.S. financial markets—enhancing the power of large companies that are designated as systemically important and threatening the survivalof those that do not receive that endorsement. Underlying the plan is the erroneous belief—shattered by the cata-strophic condition of the heavily regulated banking sector—that regulation can prevent risk-taking and failure. Although the plan could get through Congress if the financial industry remains inert and apathetic, the weaknessofthe administration’scase suggests that it is vulnerable to determined opposition.
March/April 2009
Peter J. Wallison (pwallison@aei.org) is the Arthur F. BurnsFellow in Financial Policy Studies at AEI.
Key points in this
Outlook 
:
•Athorough analysis of the Obama adminis-tration’s financial regulation proposal.•Firms deemed “too big to fail” will receivecompetitive advantages.•Aspecial resolution system will be a recipefor repeated bailouts.•The cases of AIG and Lehman do not providearationale for the administration’s plans.•Asystemic risk regulator is not a seer.•The financial world, largely silent about theadministration’s proposal, should speak upabout its flaws.
 
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funding costs, exactly the advantage that allowed Fannieand Freddie to drive all competition from their market.Indeed, it may well be that the systemically importantfirms will be more formidable competitors than Fannie andFreddie, which were restricted by their charters fromexpanding beyond their secondary market role. There isno indication that systemically important firms will besimilarly restricted.In light of the competitive danger that the administra-tion’s proposal creates for smaller firms, the lack of anyadverse reaction thus far in the financial services sector issurprising. It is also surprising that the administration wouldback a plan that will inevitably create more firms—ratherthan fewer—that are too big to fail. It is not hard to under-stand why the largest firms might not see the plan as athreat; they might believe that the government support theyreceive will be more helpful than harmful in the future. Butit is harder to understand why there seems to be so littlevocal opposition at this point from the many smaller firms—insurance companies, securities firms, hedge funds, andfinance companies—that will be forced to face government-aided competition. Perhaps they believe that these changesare inevitable. There is little else to explain the support forthe idea from such organizations as the U.S. Chamber of Commerce and the Securities Industry and FinancialMarkets Association—two organizations that are normallyskeptical about excessive regulation and object to thegovernment picking winners and losers. This
Outlook
willreview the administration’splan in detail, show the weak-ness of the administration’s argument, and outline why andhow it will make major changes in the structure of and com-petitive conditions in the financial sector of the economy.
The Administration’sPlan
In congressional testimony on March 26, 2009, SecretaryGeithner described the major features of the administra-tion’s plan:Toensure appropriate focus and accountabilityfor financial stability we need to establish a singleentity with responsibility for consolidated supervi-sion of systemically important firms. . . . Thatmeans we must create higher standards for allsystemically important financial firms regardless of whether they own a depository institution, toaccount for the risk that the distress or failure of such a firm could impose on the financial system andthe economy....[W]e must create a resolution regime that providesauthority to avoid the disorderly liquidation of any nonbank financial firm whose disorderly liquida-tion would have serious adverse consequences onthe financial system or the U.S. economy. . . .Depending on the circumstances, the FDIC and theTreasury would place the firm into conservatorshipwith the aim of returning it to private hands or areceivership that would manage the process of wind-ing down the firm.
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The last sentence makes clear that this is not simply aproposal for winding down failed financial institutions inan orderly way; instead, it contemplates a “conservator-ship,” which would allow the government to take controlof a failing company and restore it to financial health. Thisapproach complements the idea that systemically impor-tant firms are too big to fail and creates the vehicle thatwould actually prevent their failure. Underlying the plan,of course, is the glaringly false assumption that regulationcan prevent excessive risk-taking and failure by financialfirms. One glance at the catastrophic condition of theheavily regulated banking industry should convince any-one who thinks about it objectively that regulation isnot the panacea its proponents suggest. The administrationhas not yet decided what agency would be the systemicregulator, and it has not formally named the agency thatwould have the authority to take over and resolve or rescuefailing or failed nonbank financial firms. The FederalDeposit Insurance Corporation (FDIC) seems to be thefrontrunner for the resolution agency; the Federal Reservehas been mentioned frequently as the likely systemic regu-lator,
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but this raises serious policy issues.
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The Consequences of Designating Firms asSystemically Important
The dangers to competition inherent in the administra-tion’s plan arise in two ways: direct benefits to firms thatoffer products enhanced by the apparent financial sound-ness of the firm that offers them, and indirect benefitsthrough a lower cost of funds for firms that are perceived tobe less risky than their competitors. In insurance, for exam-ple, where the financial soundness of a company couldmake a competitive difference, the companies that canboast that they are too big to fail are likely to be more suc-cessful in attracting customers than their smaller competi-tors. Similarly, but more indirectly, firms that can boast thatthey are systemically important and thus too big to fail
 
would—like Fannie Mae and Freddie Mac—appear lessrisky as borrowers than firms that are not protected by thegovernment, and this will produce lower financing costs.Eventually, these firms will be able to use their superiorfinancing opportunities to drive competition from theirmarkets. Overall, the systemically significant firms willbe subject to less market discipline, will be able to takemore risks than others, will grow larger in relation toothers in the same industry, and will gradually acquiremore and more of their less successful competitors. Even-tually, we will see a market much like the housing marketthat Fannie and Freddie came to dominate, with a fewgiant companies, chosen by the government, that havepushed out all significant competition.It is, of course, possible that the opposite could occur.The companies that are designated as systemically signifi-cant could face so much costly regulation that theybecome less profitable than their competitors. Indeed,some supporters of designating systemically significantfirms have argued that systemically important firms willface such onerous regulation that no firm will want thehonor. But this seems unlikely. Yes, it is possible to regulatesystemically important companies so strictly that they arenot able to compete effectively with others, but such apolicy would be self-defeating. If regulation so impairsthe operations of systemically important companies thatthey cannot carry on their businesses efficiently, that willonly mean they will have to be bailed out sooner. The fail-ure of companies under regulatory supervision is a seriousindictment of the regulator’s effectiveness, and regulatorstry hard to avoid it. Regulatory forbearance—refusal tostep in and close failing institutions—is a product of thistendency and one of the most significant causes of thesavings and loan (S&L) and banking crisis of the late1980s and early 1990s. So pervasive was regulatory for-bearance for S&Ls and banks during that period that apolicy called “prompt corrective action” was written intothe Federal Deposit Insurance Corporation ImprovementAct of 1991 (FDICIA), the tough banking legislation thatwassupposed to prevent future widespread bank losses.Asdiscussed below, it has not worked as hoped. Regula-tory forbearance seems to continue. The twenty-one banksthat have been resolved by the FDIC over the past yearhave averaged losses on assets of 24 percent,
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even thoughprompt corrective action was intended to enable institu-tions to be closed before they had suffered any losses. Con-trary to the notion that regulators could be tough onsystemically important firms, experience shows that theytry to help their regulated clients succeed.
The Administration’s Plan for Resolvingor Rescuing Failing Financial Firms
The extraordinary FDIC losses on failing banks should beawarning to anyone who contemplates a nonbankruptcysystem for resolving failed or failing financial institutions.In the few cases in which regulators will actually closeinstitutions under the administration’s plan, the losseswill be expensive for taxpayers. In most cases, however,regulatory forbearance will ensure that excuses will befound to rescue most financial firms, also at taxpayerexpense. A rescue not only avoids embarrassment for theregulator but is also generally approved by Congressbecause it saves jobs and avoids financial disruption. It canbe safely predicted, accordingly, that for the largest institu-tions—those designated as systemically important—thenew
resolution
system will simply become a
bailout
system,with the taxpayers handed the bill. The capital marketsunderstand this tendency on the part of regulators. That iswhy the administration’s proposal for a special resolutionsystem for failing financial firms increases the likelihoodthat the capital markets will see systemically importantfirms as less likely than others to be allowed to fail, andthus less risky as borrowers.Secretary Geithner defended this portion of his plan bysuggesting that it is merely doing for nonbanks what theFDIC already does for banks. This argument omits the keyreasons for FDIC’s resolution process—why it exists andwho pays for it. Commercial banks and other depositoryinstitutions perform a special role in our economy. Theyoffer deposits that can be withdrawn on demand or used topay others through an instruction such as a check. If abank should fail, its depositors are immediately deprived of the ready funds they expected to have available for suchthings as meeting payroll obligations, buying food, orpaying rent. Because of fear that a bank will not be able topay in full on demand, banks are also at risk of “runs”—panicky withdrawals of funds by depositors. Although runscan be valuable and efficient market discipline for insol-vent banks, they can be frightening experiences for thepublic and disruptive for the financial system. The uniqueattribute of banks—that their liabilities (deposits) may bewithdrawn on demand—is the reason that banks, andonly banks, are capable of creating a systemic event if theyfail. If a bank cannot make its payments to other banks,the others can also be in trouble, as can their customers.That is systemic risk, but it is unlikely to be caused byany other kind of financial institution because thesefinancial institutions—securities firms, hedge funds,
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