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Why We Must End Too Big to Fail

Why We Must End Too Big to Fail

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Published by Bryan Castañeda

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Published by: Bryan Castañeda on Apr 23, 2012
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04/23/2012

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As a nation, we ace a distinct choice. We can perpetu-ate
too big to ail
, with its inequities and dangers, or wecan end it. Eliminating TBTF won’t be easy, but the vitalityo our capitalist system and the long-term prosperity itproduces hang in the balance.
2
Federal reserve Bank oF dallas 2011 annual report
 
Choosing the Road to Prosperity
Why We Must End Too Big to Fail—Now
by Harvey Rosenblum
Federal reserve Bank oF dallas 2011 annual report
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ore than three years ater a crippling nancial crisis, the American economystill struggles. Growth sputters. Job creation lags. Unemployment remains high.Housing prices languish. Stock markets gyrate. Headlines bring reports o ashrinking middle class and news about governments stumbling toward bankruptcy, athome and abroad.Ordinary Americans have every right to eel anxious, uncertain and angry. Tey haveevery right to wonder what happened to an economy that once delivered steady progress.Tey have every right to question whether policymakers know the way back to normalcy.American workers and taxpayers want a broad-based recovery that restores con-dence. Equally important, they seek assurance that the causes o the nancial crisis havebeen dealt with, so a similar breakdown won’t impede the fow o economic activity.Te road back to prosperity will require reorm o the nancial sector. In par-ticular, a new roadmap must nd ways around the potential hazards posed by thenancial institutions that the government not all that long ago deemed “too big toail”—or BF, or short.In 2010, Congress enacted a sweeping, new regulatory ramework that attemptsto address BF. While commendable in some ways, the new law may not prevent thebiggest nancial institutions rom taking excessive risk or growing ever bigger.BF institutions were at the center o the nancial crisis and the sluggish recov-ery that ollowed. I allowed to remain unchecked, these entities will continue posinga clear and present danger to the U.S. economy.As a nation, we ace a distinct choice. We can perpetuate BF, with its inequitiesand dangers, or we can end it. Eliminating BF won’t be easy, but the vitality o ourcapitalist system and the long-term prosperity it produces hang in the balance.
M
 
4
Federal reserve Bank oF dallas 2011 annual report
When competition declines, incentives oten turn per-verse, and sel-interest can turn malevolent. That’s whathappened in the years beore the fnancial crisis.
Flaws, Frailties and Foibles
Te nancial crisis arose rom ailureso the banking, regulatory and politicalsystems. However, ocusing on acelessinstitutions glosses over the undamen-tal act that human beings, with all theirfaws, railties and oibles, were behind thetumultuous events that ew saw comingand that quickly spiraled out o control.
Complacency
Good times breed complacency—notright away, o course, but over time asmemories o past setbacks ade. In 1983,the U.S. entered a 25-year span disruptedby only two brie, shallow downturns, ac-counting or just 5 percent o that period
(Exhibit 1)
. Te economy perormedunusually well, with strong growth, lowunemployment and stable prices.Tis period o unusual stability andprosperity has been dubbed the GreatModeration, a respite rom the usual tumulto a vibrant capitalist economy. Beore theFederal Reserve’s ounding in 1913, recessionheld the economy in its grip 48 percent o the time. In the nearly 100 years since theFed’s creation, the economy has been inrecession about 21 percent o the time.When calamities don’t occur, it’s hu-man nature to stop worrying. Te worldseems less risky.Moral hazard reinorces complacency.Moral hazard describes the danger thatprotection against losses encourages riskierbehavior. Government rescues o troublednancial institutions encourage banks andtheir creditors to take greater risks, know-ing they’ll reap the rewards i things turnout well, but will be shielded rom losses i things sour.In the run-up to the crisis o 2008, thepublic sector grew complacent and relaxedthe nancial system’s constraints, explicitlyin law and implicitly in enorcement. Ad-ditionally, government elt secure enoughin prosperity to pursue social engineeringgoals—most notably, expanding homeownership among low-income amilies.At the same time, the private sectoralso became complacent, downplayingthe risks o borrowing and lending. Forexample, the traditional guideline o 20percent down payment or the purchaseo a home kept slipping toward zero, es-pecially among lightly regulated mortgagecompanies. More money went to thosewith less ability to repay.
1
 
Greed
You need not be a reader o AdamSmith to know the power o sel-inter-est—the human desire or material gain.Capitalism couldn’t operate without it.Most o the time, competition and the ruleo law provide market discipline that keepssel-interest in check and steers it towardthe social good o producing more o whatconsumers want at lower prices.When competition declines, incen-tives oten turn perverse, and sel-interestcan turn malevolent. Tat’s what happenedin the years beore the nancial crisis. Newtechnologies and business practices reducedlenders’ “skin in the game”—or example,consider how lenders, instead o retainingthe mortgages they made, adopted thenew originate-to-distribute model, allowingthem to pocket huge ees or making loans,packaging them into securities and sellingthem to investors. Credit deault swaps edthe mania or easy money by opening acasino o sorts, where investors placed betson—and a ew nancial institutions soldprotection on—companies’ creditworthi-ness.Greed led innovative legal minds topush the boundaries o nancial integrity

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