The US Government’s big mistake was allowing Lehman Brothers to go bust because it under-estimated the impact that would have on the market. Regulators misjudged the systemic importance of that collapse and the psychological fallout from its failure. They also made the mistake of assuming that the way to avoid moral hazard and make capitalism work is to produce real and painful consequences for recklessness and misjudgments. Regulators were blind to the the inter-connectedness of the global system. As a result, the market imploded with the collapse of Lehman Brothers.
As a result, former Securities and Exchange Commission chairman Arthur Levitt says we need to have a new system that allows institutions to fail without creating a run on the market.
Writing in the Financial Times, Levitt says we need a system that ensures investors, long-term debt holders, lenders and management suffer pain commensurate with the risks they allowed an institution to take. Secondly, we need some sort of insurance that creates a buffer. Also, regulators should not lose sight of the potential impact that institution’s failure will have on the overall economy. And finally, regulators should keep in mind the warnings of Lady Macbeth: “If t’were done, when ’tis done, then t’were well t’were done quickly”. If failure is the only option, then doing it quickly with contractual obligations sold to healthy firms, assets sold off, intra-institutional lending, cancelling debt or equity and special protection to certain creditors.
Levitt writes: “We need a process that is known in advance, includes the efficient and orderly write-down of assets and restructuring of debt, and draws on public funds only as a last resort. We need a resolution authority created explicitly to impose discipline on those with the most power to influence the level of risk-taking: the holders of both equity and debt of institutions that may be ‘too big to fail’.
“What we must also recognise is that in our desire to remove “too big to fail” from the lexicon, we should avoid creating a greater degree of panic among investors when large institutions hit bumps in the road.”
We definitely need some sort of process in place. Because we are likely to see more failures, we need some sort of system that ensures it doesn’t destroy other investments.
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