Toward overkill

The Federal Reserve and the Securities and Exchange Commission formalized earlier this month a working agreement that had been in place since the bailout of Bear Stearns investment bank in March, the first time in its history that the Fed had made its discount window (i.e., money to bridge a potential crisis) available to an institution other than a thrift or a commercial bank. The two agencies will share information about investment banks, which have until now been overseen exclusively by the SEC.

This could be seen as simply a minor bureaucratic adjustment except, as William Niskanen, chairman of the Cato Institute and a member of the Council of Economic Advisers during the Reagan administration, said: Taken in conjunction with other developments it presages a move toward direct regulation of investment banks by the Fed. This is an unnecessary step that could stifle innovation in the securities industry without providing the stability some people believe as a matter of faith that regulation provides. In fact, such regulation could be an inducement to assuming the kind of risky investment that contributed in some measure to the mortgage meltdown.

The first reason is moral hazard. This occurs when the government acts as a backup to firms, ensuring they don't go out of business - or their creditors or depositors are not harmed if they do. When people believe "the government has your back," it can induce unusually risky behavior.

For example, federal deposit insurance may be an important protection for depositors, but it also can encourage risky behavior by banks and other institutions, as happened in the 1980s, when 1,600 banks and a third of the country's savings and loans went under, eventually costing taxpayers some $150 billion. The 1985 collapse of Cincinnati-based Home State Savings Bank led Democratic Gov. Dick Celeste to order the closing of all the state's savings and loans.

Regulation is designed to counteract moral hazard by assuring proper procedures and accounting methods. But banks are among the most heavily regulated in the country, and that didn't prevent many from failing in the 1980s as they operated under even broader deposit coverage and loosened real estate lending rules. Regulators are only human and cannot foresee every possible calamity that might occur, and regulation is seldom strong enough to overcome moral hazard.

Another way of encouraging responsible behavior is market discipline, which occurs when investors know their own funds are at risk, which encourages them to be especially diligent about the kinds of institutions in which they invest. The ultimate example of market discipline is to allow a firm that is mismanaged or has made unwise decisions to fail.

One can make a case that commercial banks, at least their depositors, should be protected against failure and therefore need regulation. However, investment banks don't make loans based on deposits, but buy securities, which means they have collateral that can be turned into money when times get tough. One could argue that it was necessary to bail out Bear Stearns because the market was so roiled by the mortgage crisis that this was impossible - though not everybody agrees. Regardless of whether it was really necessary, it was a unique circumstance. It hadn't happened for 70 years.

It has been argued that some firms are "too large to fail" because their failure would create ripples through the financial system that could bring it all crashing down, or at least create losses and undue instability elsewhere. However, during the 1990s, two major investment banks, Drexel Burnham and Kidder Peabody, were allowed to fail. The market accepted this with barely a hiccup and most people have forgotten their names now.

The special authority used to bail out Bear Stearns creditors is scheduled to expire in September, although Bernanke has hinted it may be extended. The best course would be to let it expire. Allowing the next investment bank that gets into trouble simply to fail would be a far more effective way to discourage risky behavior than having the Fed micromanage investment bankers.