An Ugly Future of 'Systemically Important' Institutions
In a recent appearance on Charlie Rose, General Electric Chairman Jeffrey Immelt commended the Chinese government's effectiveness: "The one thing that actually works-state run communism may not be your cup of tea, but their government works. . . . Typically, what they're doing makes sense. . . . They have five year plans." Mr. Immelt's appreciation for the Chinese approach to governing looks as if it is going to come in handy. GE Capital is one of the first companies selected for designation as systemically important by the Financial Stability Oversight Council. The designation forms the basis for a cozy relationship between business and government along the lines of the Chinese model.
Once the FSOC's designation is final, it will be regulated by the Federal Reserve Board of Governors. The Fed, under Dodd-Frank, will be deeply embedded in the business and decision-making of designated companies. The Fed has broad authority to write whatever rules it wants. But, at a minimum, designated companies will potentially face heightened capital requirements, leverage limits, liquidity requirements, concentration limits, and risk management requirements. Designated companies may also face limits on how reliant they can be on short-term debt, as well as heightened disclosure requirements. They will also have to write, and get government approval for, their death plans-roadmaps for winding down if they get in trouble. If the government doesn't approve their plans, they will face forced divestitures. The Fed will examine designated companies and subject them to stress tests to see how they would weather a change in economic conditions.
At first blush, this sounds great-the biggest financial companies will get an extra dose of regulation. The new regulatory costs will serve as a de facto tax on being big, ensuring that these big entities are on an extra tight leash and can't do anything stupid that ends up costing the rest of us money. The extra resources expended by the companies and their regulators do not, however, guarantee success. If regulatory efforts fail to foster the financial stability of designated institutions or-even worse-undermine the stability of one or more regulated entities, regulators will be under strong pressure to cover their tracks by taking extraordinary efforts to stave off utter collapse.
AIG's CEO went to Tim Geithner in the summer of 2008 to warn him of the liquidity strains his company was under and ask for help. Mr. Geithner didn't leap into action; the Federal Reserve Bank of New York, of which he was head, was not AIG's regulator and so did not pay a lot of attention to AIG until the company was on the verge of bankruptcy. AIG was one of the companies selected by the FSOC on Monday, so the Fed will oversee it. A liquidity crunch at the company would imply not only a failure by the company, but a failure by the Fed. If AIG's CEO were to come running to the Fed, we would likely see efforts like those used during the last crisis to rescue large, heavily regulated financial institutions.
Former Federal Deposit Insurance Corporation Chairman Sheila Bair, in her book recounting the crisis, tells of the Fed's tireless efforts to resuscitate the ailing Citigroup. According to Bair, emergency programs were designed and redesigned with Citi in mind and the parameters for the bank stress test were adjusted with Citi in mind. Citi's regulators couldn't let the company fail without taking a public relations hit, so they devised imaginative ways to prop it up. Bair recalls that "the whole tenor of the conversation was that the government owed it to Citi to get it out of trouble. As Hank [Paulson] said in his book, ‘If they go down, it's our fault.'"
FSOC selected its first systemically important financial institutions on Monday, but celebration is not in order. Sure, we might get a nice government plan for the financial industry. But under the heavy hand of government, we'll lose the market dynamism that serves consumers and investors and open the door to future taxpayer bailouts. The result? a government-private sector partnership that even the Chinese government could be proud.