The Financial Crisis and Reform: A Close-up View

Published on February 22, 2010

Proposals to break up the major U.S. banks risk making the system more “fragile,” warned Randall Kroszner, Norman R. Bobins Professor of Economics and former member of the Federal Reserve Board of Governors.

Kroszner, who spoke at a Global Leadership Series event at the school’s London campus February 22, urged policymakers to focus instead on the increased interconnectedness in financial markets when implementing regulatory reforms.

He also recalled “heart-pounding” moments during the 2008 Bear Stearns crisis when he had to make real-time decisions to approve massive interventions that he admitted were still “on his soul.”

Kroszner said policymakers must learn lessons from the crisis when designing reforms, and that they should focus on the increased interconnectedness of financial institutions and markets rather than concentrate on the activities or scope of individual firms. “It is very important to give priority to reforms that address fragilities due to linkages across markets and institutions in the system,” he said.

He said a revival of the Glass-Steagall Act that separated commercial and investment banking, or the so-called “Volcker Rule” barring investment banks from proprietary trading and running hedge or private equity funds, would have unintended consequences. “This pressure to break things up is only going to increase these interconnections and potentially make the system more fragile,” he said.

The priority should be to make market infrastructure more robust, particularly by improving the bankruptcy resolution regimes. The financial meltdown of September 2008, when counterparties, funders, and customers all pulled back from the market, showed it was crucial to establish greater certainty for investors, Kroszner said.

This included “living wills” to give guidance on how a troubled institution would operate as it was wound down, and pre-packaged bankruptcy so parties knew how contracts would be dealt with if an institution failed. “Ultimately, what we have to do is to provide sufficient comfort to policymakers that the consequences of failure can be contained. Otherwise you are going to have banks that are too interconnected to fail.

“Unfortunately I don’t think this has been the priority for the G20. They have been focusing on capital. And capital is important, but that should not be to the exclusion of these other crucial issues. The bankruptcy regime is a first-order, cross-border issue requiring international coordination, and I think that should be the priority for the G20,” he said.

Asked how he coped during Bear Stearns, Kroszner relived the moment when the secretary of the Fed’s Board listed the decisions they had to take on the afternoon of Sunday March 16, 2008. “You need an analytical framework to make decisions quickly,” he said, adding that he drew on his research into the Great Depression.

He said none of the members of the Fed Board was “predisposed to intervening. But in the circumstances, we felt we needed to do what was necessary to ensure we did not have a repeat of the Great Depression.”

Kroszner supported the decision to provide extraordinary levels of liquidity because “to stand by was too big and too difficult a risk to take. Even though a lot of the decisions were controversial and I didn’t like making them at the time, they are on my soul. Overall, I believe, their effects have been positive and, ultimately, history will judge.”

The event was sponsored by Luexmbourg Financial Group, whose chairman and CEO is Johan Groothaert, '93.

— Phil Thornton