Bad History, Worse Policy by Peter J. Wallison

Author:Peter J. Wallison
Language: eng
Format: epub
ISBN: 9780844772400
Publisher: AEI Press

Through interpretations like this, the explanation for why Bear was rescued evolved into a conclusion with far greater policy significance; under the new interpretation of Lehman, all large financial firms—because of their purported interconnectedness—were inherently a danger to financial-system stability. This provided a rationale for extensive government regulation, since regulation was believed (again, without much evidence) to be effective in reducing the likelihood of a financial institution’s failure and thus the chances of another financial crisis. Writing in the Journal of Credit Risk, one commentator made this connection explicit: “This crisis—and the cases of firms like Lehman Brothers and AIG has made clear that certain large, interconnected firms and markets need to be under a more consistent and more conservative regulatory regime. It is not enough to address the potential insolvency of individual institutions—we must also ensure the stability of the system itself.”109

That is exactly the approach the Obama administration adopted upon taking office. Through use of the interconnectedness idea, it became possible for the administration to propose a comprehensive system of regulation for the largest nonbank financial firms, going far beyond any regulatory regime ever envisioned in the past. This extensive regulation was justified by arguing that if one of these large firms were to fail it could—like Lehman—cause instability in the financial system, just as Bernanke had argued that the failure of Bear Stearns could have undermined the financial condition of “thousands” of its counter-parties. The fact that this never occurred when Lehman failed was ignored. For example, in a statement on September 15, 2009, the anniversary of Lehman’s bankruptcy, President Barack Obama stated:

While holding the Federal Reserve fully accountable for regulation of the largest, most interconnected firms . . . we’ll also require these financial firms to meet stronger capital and liquidity requirements and observe greater constraints on their risky behavior. That’s one of the lessons of the past year. The only way to avoid a crisis of this magnitude is to ensure that large firms can’t take risks that threaten our entire financial system, and to make sure they have the resources to weather even the worst of economic storms.110

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