The Corner

Bernanke’s Impossible Risk-Management Dream

Ben Bernanke talked today in New York. In the Q&A, the Federal Reserve chairman said that one of Washington’s goals should be to end our 25-year regime of financial-industry bailouts. That’s good, because the expectation of bailouts is incompatible with free markets. But Bernanke, along with much of the rest of Washington, is struggling on how to get there.

How to ensure that financial companies have the “freedom to fail” (in Bernanke’s excellent phraseology), so that the firms — and the economy that they support — can enjoy the discipline of the marketplace?

Bernanke said that a big part of the answer lies in allowing regulators the discretion to decide, on a case-by-case basis, which financial firms are taking acceptable risks and which ones are taking unacceptable risks.

“If supervisors look at a large banking organization and they determine that the company is not able to manage the risks associated with that activity or it creates other risks to safety and soundness or it doesn’t have capital to engage in the activities, the supervisor should be allowed by law to have the firm divest itself of those activities,” Bernanke said.

Such top-down government determination of risk, in Bernanke’s view, would lower the effect of failure on the rest of the economy.

This strategy is exactly what not to do (one of the points of my forthcoming book).

How would a government supervisor know whether individual firms are taking reckless risks, from the perspective of the entire system? Regulators thought five years ago that AAA-rated mortgages and other similarly structured securities were riskless. They allowed financial firms to borrow heavily against them, relative to other investments.

Regulators’ determination left the entire system vulnerable to a catastrophic mistake, because it allowed investors, including banks, to build up so much debt with few loss absorbers (non-borrowed money). Today, regulators think that government bonds are riskless — and they may be just as catastrophically wrong about that, too.

The government cannot know what is risky in advance. So it should not try to dictate such predictions from the top down. That’s how you get a decision that one huge asset class is perfectly safe when it’s not.  

As Congress debates financial regulation, observers should view certain phrases, including “case by case,” “discretion,” and “risk management,” as red flags that we’re on the wrong track. Under a “case by case” regulatory system, the creators and sponsors of any new investment structure know that all they need to do to hit the jackpot is to convince the government that their unique structure has erased all risk.

The right words are uniformity and consistency. Regulators should prescribe borrowing limits for securities, derivatives, and other investments on a uniform basis within broad investment classes.

They should stick to their rules no matter how convincing bankers are that this time, they’ve structured away all risk in some trillion-dollar pile of debt, thus eliminating the need for borrowing limits against investments in that pile.

When the government does its job properly, individual firms can then be free to assess risk on a bottom-up basis. They can demand a higher rate of return for assets that they perceive to be riskier, and a lower rate for assets that they perceive to be less risky.

If private firms are wrong, as they will be sometimes, so what? The system as a whole will be better protected, through reasonable, consistent borrowing constraint. The stakes are not as high as when the government is wrong.

Bottom line: Diversity in risk assessment is great, and indeed vital to free markets. But it should come from the private sector, bottom-up. Uniformity should come from the government, top-down.

It is impossible for the government to manage systemic risk. It is possible for the government better to protect the economy against the worst effects of systemic risk. But we can’t do the latter until we understand that we can’t do the former.  

— Nicole Gelinas, contributing editor to the Manhattan Institute’s City Journal, is author of the forthcoming After the Fall: Saving Capitalism from Wall Street — and Washington.