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In a presentation to the US House Committee on Financial Services last Thursday in Washington, Henry Paulson, the US Treasury Secretary, said that “For market discipline to effectively constrain risk, financial institutions must be allowed to fail.”
Paulson outlined his proposals for equipping the SEC and the Federal Reserve to be able to avert events that posed unacceptable levels of systemic risk but reminded the Committee that regulation alone was not the answer. The Fed needed the authority to access necessary information - whether from a commercial bank, investment bank, a hedge fund, or another type of financial institution - and it needed the tools to intervene to mitigate systemic risk in advance of a crisis. But financial institutions had to be encouraged to exercise market discipline.
“Market discipline is also critical to the health of our financial system, and must be reinforced” Paulson said, “because regulation alone cannot eliminate all future bouts of market instability. For market discipline to be effective, market participants must not expect that lending from the Fed, or any other government support, is readily available. I know from firsthand experience that normal or even presumed access to a government backstop has the potential to change behavior within financial institutions and with their creditors. It compromises market discipline and lowers risk premiums, ultimately putting the system at greater risk.”
However, Paulson believed that market practices and discipline on the part of financial institutions and investors were improving and that regulators were successfully enhancing guidance, issuing new rules, and communicating more effectively across agencies - domestically and internationally.
Paulson confirmed his direction as laid out a “Blueprint for a Modernized Financial Regulatory Structure”, released at the end of March, where he described a regulatory model focused on the reasons for regulation - market stability, safety and soundness of institutions supported by a federal guarantee, and the protection of consumers and investors. Paulson said the advantages of this approach were “its timelessness and its flexibility and that, because it is organized by regulatory objective rather than by financial institution category, it can more easily respond and adapt to the ever-changing marketplace”. He called for its implementation and said that events such as Bear Sterns and the current credit turmoil only supported its needs.
However, it looks like Fannie Mae and Freddie Mac, the US government housing finance backstops, will not be among those allowed to fail. On Sunday, Paulson announced that it was requesting regulatory changes that would allow it to support these two organizations with funds and share purchases.
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