Robert Pozen, one of the most thoughtful and experienced analysts of financial services and the economy, has written an insightful new book, Too Big to Save? How to Fix the U.S. Financial System.
I have argued that some of the financial service companies requiring government bailouts were too big to succeed, that their very size made them ungovernable. Pozen documents this with meticulous and devastating detail. The book is worth buying just for the chapter on the role that GAAP accounting played in hiding the risks of derivative investments. I especially like his crisp description of the criteria that should be applied in bailouts: one of the key functions of the banking system is to process payments through the Federal Reserve network or where the obligations are so large to so many other institutions that it would cause "widespread havoc throughout the financial sector.
He shows that many of the recipients of TARP money failed to meet these criteria. "Indeed, if we take the position that all large banks are too big to fail, we will create a self-fulfilling prophecy." And he takes the provocative position that "(t)he adverse repercussions of Lehman's failure resulted primarily from the implicit expectations created by the federal bailout of all bond holders in Bear Stearns earlier in 2008. If the federal government had let Bear fail, Lehman would have moved very quickly to bolster its financing sources and find an acquisition partner."
Pozen correctly says that bailouts can "undermine the incentives of private investors to bring market discipline to bear on large banks" and give the recipient an unfair advantage over its peers. He also calls on the Justice Department to prevent any further mergers that would increase the concentration at the top of the financial sector. But he believes that it is "impractical to break up existing mega banks into small enough pieces to achieve a competitive financial sector," so that feels a bit like locking the barn door after the horse has been stolen.
I would like to have seen Pozen spend more time on the failure of institutional shareholders like the bailed-out institutions themselves to do a better job of assessing and responding to the risks of CDOs and sub-prime mortgages. While he does include an excellent set of guidelines for structuring executive compensation in the future, he does not urge investors to require these improvements in portfolio companies. He does recommend a stronger board of directors, including "special master"-type experts and a better way to promote shareholder-nominated candidates and to remove unsatisfactory members of boards with majority votes against them. But unless firms like Pozen's former employer, Fidelity, take the responsibility for exercising these rights, they cannot be meaningful.
Nell Minow - Editor
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