A global controversy is raging: what new regulations are required to restore confidence in the financial system and ensure that a new crisis does not erupt a few years down the line. Mervyn King, the governor of the Bank of England, has called for restrictions on the kinds of activities in which mega-banks can engage.

British Prime Minister Gordon Brown begs to differ: after all, the first British bank to fall – at a cost of some $50 billion – was Northern Rock, which was engaged in the "plain vanilla” business of mortgage lending.

The implication of Brown’s observation is that such restrictions will not ensure that there is not another crisis; but King is right to demand that banks that are too big to fail be reined in.

In the United States, the United Kingdom, and elsewhere, large banks have been responsible for the bulk of the cost to taxpayers.

America has let 106 smaller banks go bankrupt this year alone.  It’s the mega-banks that present the mega-costs.

The crisis is a result of at least eight distinct but related failures:

• Too-big-to-fail banks have perverse incentives; if they gamble and win, they walk off with the proceeds; if they fail, taxpayers pick up the tab.

• Financial institutions are too intertwined to fail; the part of AIG that cost America’s taxpayers $180 billion was relatively small.

• Even if individual banks are small, if they engage in correlated behavior – using the same models – their behavior can fuel systemic risk;

• Incentive structures within banks are designed to encourage short-sighted behavior and excessive risk taking.

• In assessing their own risk, banks do not look at the externalities that they (or their failure) would impose on others, which is one reason why we need regulation in the first place.

• Banks have done a bad job in risk assessment – the models they were using were deeply flawed.
• Investors, seemingly even less informed about the risk of excessive leverage than banks, put enormous pressure on banks to undertake excessive risk.

• Regulators, who are supposed to understand all of this and prevent actions that spur systemic risk, failed. They, too, used flawed models and had flawed incentives; too many didn’t understand the role of regulation; and too many became "captured” by those they were supposed to be regulating.

If we could have more confidence in our regulators and supervisors, we might be more relaxed about all the other problems. But regulators and supervisors are fallible, which is why we need to attack the problems from all sides.

There are, of course, costs to regulations, but the costs of having an inadequate regulatory structure are enormous. We have not done nearly enough to prevent another crisis, and the benefits of strengthened regulation far outweigh any increased costs.

King is right: banks that are too big to fail are too big to exist.  If they continue to exist, they must exist in what is sometimes called a "utility” model, meaning that they are heavily regulated.

In particular, allowing such banks to continue engaging in proprietary trading distorts financial markets. Why should they be allowed to gamble, with taxpayers underwriting their losses? What are the "synergies”?

Can they possibly outweigh the costs? Some large banks are now involved in a sufficiently large share of trading (either on their own account or on behalf of their customers) that they have, in effect, gained the same unfair advantage that any inside trader has.

This may generate higher profits for them, but at the expense of others. It is a skewed playing field – and one increasingly skewed against smaller players.

Who wouldn’t prefer a credit default swap underwritten by the US or UK government; no wonder that too-big-to-fail institutions dominate this market.

The one thing nowadays that economists agree upon is that incentives matter. Bank officers got rewarded for higher returns – whether they were a result of improved performance (doing better than the market) or just more risk taking (higher leverage).

Either they were swindling shareholders and investors, or they didn’t understand the nature of risk and reward. Possibly both are true.

Either way, it’s discouraging.
Given the lack of understanding of risk by investors, and deficiencies in corporate governance, bankers had an incentive not to design good incentive structures. It is vital to correct such flaws – at the level of the organization and of the individual manager.

That means breaking up too-important-to fail (or too-complex-to-fix) institutions. Where this is not possible, it means stringently restricting what they can do and imposing higher taxes and capital-adequacy requirements, thereby helping level the playing field.

The devil, of course, is in the details – and big banks will do what they can to ensure that whatever charges are imposed are sufficiently small that they do not outweigh the advantages gained from being underwritten by taxpayers.

Even if we fix bank incentive structures perfectly – which is not in the cards – the banks will still represent a big risk. The bigger the bank, and the more risk-taking in which big banks are allowed to engage, the greater the threat to our economies and our societies.

These are not matters of black and white: the more we limit the size, the more relaxed we can be about these and other details of regulation.

That is why King, Paul Volcker, the United Nations Commission of Experts on Reforms of the International Monetary and Financial System, and a host of others are right about the need to curb the big banks.

What is required is a multi-prong approach, including special taxes, increased capital requirements, tighter supervision, and limits on size and risk-taking activities.

Such an approach won’t prevent another crisis, but it would make one less likely – and less costly if it did occur.

Joseph E. Stiglitz is University Professor at Columbia University and the winner of the 2001 Nobel Prize in economics.  His forthcoming book Freefall will be published this winter.

Copyright: Project Syndicate, 2009.
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