WASHINGTON (CN) – Federal Reserve Chair Ben Bernanke called for a more concrete end to the era of “too big to fail” institutions during a Financial Crisis Inquiry Commission hearing Thursday, saying a promise by the Obama administration that the government will not bail out large Wall Street firms in the future is not enough.
“If the crisis has a single lesson, it is that the too-big-to-fail problem must be solved,” Bernanke said before the bipartisan commission appointed to examine the causes of the 2008 economic meltdown.
“Few governments will accept devastating economic costs if a rescue can be conducted at a lesser cost,” Bernanke said. “Even if one administration refrained from rescuing a large, complex firm, market participants would believe that others might not refrain in the future.”
Bernanke defined “too big to fail” institutions are those whose size, complexity and interconnectedness are so large that their sudden liquidation would have adverse implications on the broader financial system and economy.
The problem with these mammoth firms is that they know they will likely receive government assistance if their “bets go bad,” Bernanke said, which encourages them take excessive risks. This advantage also shuts out smaller firms, which increases the market share of the larger firms and contributes to the instability of the overall financial system.
When Bear Stearns failed in March 2008, for example, a “rolling panic” occurred that turned the spotlight onto other vulnerable firms, such as Lehman Brothers, contributing to its collapse six months after Bear Stearns. “It’s just the nature of financial institutions,” Bernanke said. “They live on confidence.”
Bernanke said that while “too big to fail” institutions that were involved in the subprime mortgage crisis helped trigger the financial meltdown, vulnerabilities in the larger financial system exacerbated the crisis, ballooning it to a global scale.
“If we had had a healthy, strong, stable financial system,” Bernanke said, “it could have accepted this problem without causing this crisis.”
Bernanke called banks’ reliance on short-term, unstable lending leading up the crisis the “E. coli effect,” akin to getting E. coli into the food supply, he said.
The Fed chair also acknowledged that regulators did not have the right tools to resolve problems at the firms, further worsening the crisis.
Unlike power companies or other industries that engage in self-regulation, the financial industry is regulated almost entirely by the government, Bernanke said, which means industry participants are not looking out for the overall health of the system.
And while the Fed had the authority to write rules, the authority to enforce those rules was left to the states. As a result, he said, the Fed wasn’t looking at overall systemic risk and “didn’t see what was going on,” Bernanke said.
Bern said a combination of regulation and market discipline would give the system the “best chance” for healthy survival. He said banks needed incentives to take action for the benefit of the marketplace.
To discourage big banks from taking on excessive risk, Bernanke proposed setting more rigorous capital and liquidity requirements, adding tougher regulation and supervision, and increasing transparency and market discipline.
“We should look at a system where credit doesn’t get too easy in the boom and too tough in the downturn,” Bernanke said.
Yesterday former Lehman Brothers CEO Richard Fuld blamed federal regulators for his firm’s bankruptcy, saying regulators relied on “flawed information” to force Lehman into bankruptcy and failed to provide the same assistance to Lehman as it did to the firm’s competitors.
He said that at the time he did not believe Lehman had the collateral to back a government loan, which would leave taxpayers footing the bill. Bernanke said there was never a discussion among regulators on whether to save Lehman or not, the discussion was, “There is no choice.”
When asked by a commissioner about good reads on the crisis, Bernanke suggested “Lords of Finance,” a book by Liaquat Ahamed about the causes of the Great Depression. “We’re not the first time through,” Bernanke said, “and you’ll feel sometimes, ‘Doesn’t this seem awfully familiar?'”