Levitt: Solving Too Interconnected to Fail

Aurthur Levitt has a fantastic piece in today’s The Wall Street Journal. He argues that “There is still time for the White House and Congress to re-institute the principle of failure in our financial marketplace. It may not be as sexy as the creation of a consumer protection agency or a reorganization of the federal regulatory landscape. But it is essential.”

The two problems he believes we need to solve in order to reinforce the principle of failure are the existence of “too big to fail” and “too interconnected to fail” policy positions. Getting rid of TBTF could come through new bankruptcy laws, he argues. (Something I’ve discussed before on this blog.) Dealing with TITF means a different set of policy fixes:

All of these features make derivatives a source of “too interconnected to fail” and invite regulatory action. Several steps should follow:

First, we must officially end the unregulated status of these markets going forward—something that has been proposed before, but to no avail.

Second, rather than determining in advance which new derivatives need to be cleared, we should create incentives for that process by setting higher capital requirements on noncleared contracts. Not all derivatives will go to clearing houses—but a great majority of them will.

Third, to meet the greater volume, we need to invest in the institutional capacity of the clearing houses.

And finally, Congress should set a date certain—two years from now—at which point the special bankruptcy status of noncentrally cleared derivatives will be eliminated. This rule would only apply to new contracts.

These steps would re-introduce real credit discipline, while improving market transparency at all levels—all without forcing federal regulators to struggle to develop a rule that would somehow define a standard contract in a marketplace where variety and diversity is the norm.

Read the whole piece here.