The September-October issue of the Harvard magazine has a good article that goes into this and it’s an excellent read.
It looks first at thehistorical path the country took to get there. Before the Great Depression, about every 15 to 20 years there would be a financial panic or crisis. Once the depression hit hard, the government implemented a couple of pieces of legislation that began regulation of banking and finance and they worked. The Glass-Steagall Act, (and the Banking Act of 1935) for the most part stabilized our financial institutions. Until 1980, when bank deregulation oversight was relaxed, everything was reasonably stable. Between the late ’30s and 1980, there were no significant bank failures.
Like the savings and loan fiasco of the 1980s, the current financial crisis is the product of a mistaken regulatory philosophy—only this time the consequences have proved far more severe. In too many cases, regulators chose not to use tools they already had, or they neglected to request new tools to meet the challenges of an evolving financial system. The failure to regulate the sprawling market for credit default swaps (CDS) in the late 1990s and the Securities and Exchange Commission’s 2004 decision to allow voluntary regulation on the part of major investment firms are two particularly striking examples. …
Ironically, it is possible that the success of New Deal financial regulation actually contributed to its own undoing. After nearly 50 years of relative financial calm, academics and policymakers alike may have begun to take that stability for granted. Given this mindset, financial regulation looked like an unnecessary burden. It was as if, after sharply reducing deadly epidemics through public-health measures, policymakers concluded that these measures weren’t really necessary, since major epidemics were not much of a threat anymore.
The problem, as the article’s author sees it, is that regulators are compelled to wait until after a financial institution is in trouble (and so huge that it’s existence is tied to the safety of the economy itself) before they do anything. By that time, regulation has failed and you aren’t preventing anything, you’re desperately trying to stabilize things. The only way to deal with institutions that are too big to fail, is to literally deal with them. An ounce of prevention is worth billions of dollars worth of a cure after the fact.
The government (at least in my opinion) needs to continuously monitor financial institutions to determine which ones are big enough to threaten the stability of the economy regularly. Ones that are should face regulation designed to provent them from taking excessive risks (yeah, there are a lot of non-specific words involved – the regulation has to be flexible and, to a big degree, counter-cyclical) with limits on flaky liabilities, off-balance sheet transactions, and short-term debt. A side benefit of this regulation would be to make being that big less desirable. Don’t want to be regulated, don’t get too big to fail.
The other thing that needs to happen for businesses that are too big to fail is that we need to prevent their having to get billions in taxpayer dollars to bail them out if they start to go down. That sort of pay it in advance system has been around for over a century. It is based on mathematical models and analysis of how much need to be paid in to cover what might be paid out and it is called insurance. All the too big to fail institutions should have to pay insurance premiums that could only be used to save one of their members from failure. If they go under, treat them like the FDIC does for banks that go under. they go bankrupt. They go away. Failure is not a recoverable event.