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Anxiety over 'stressed' banking system

The results of the government's test are not surprising, but continuing to allow institutions to grow 'too big to fail' is alarming.

May 08, 2009

The results of the Federal Reserve's "stress tests" on 19 of the country's largest banks were among Washington's worst-kept secrets, with abundant leaks about the multibillion-dollar capital shortages at Bank of America and other giants. So it came as little surprise Thursday afternoon when the Fed's Board of Governors announced that only nine of the banks had come through the tests with no need for additional money.

The other 10 will be required to raise nearly $75 billion from either private investors or the federal government. That amount was less than some observers had feared, and Treasury Secretary Timothy F. Geithner called the results "reassuring." But our reaction is just the opposite. We're dismayed by the prospect of the government taking an even bigger stake in the banking industry. And we're still waiting for some market-based mechanisms to deter banks from becoming so systemically important that the government is compelled to rescue them.

It's probably misleading to describe the Fed's assessment as a test -- there was no chance of failure. In fact, the whole point was to tell financial markets two ostensibly encouraging things: that each of the 19 banks could survive a worse downturn than most economists expect (although some would need more capital to do so) and that the government stood ready to provide this capital if private investors would not. In other words, the underlying purpose of the exercise was to show that the government would not let any of the companies be scuttled by the recession, tight credit markets or their own bad bets.

That has been the Obama administration's consistent mantra, and it mirrors the approach taken by the Bush administration after the government failed to halt Lehman Bros.' precipitous demise. Lending all but ceased when Lehman defaulted, and there's no telling how much the recession would be prolonged if another major bankruptcy froze lending again. But such "too big to fail" treatment distorts the markets in a number of important and noxious ways. Companies whose solvency is implicitly guaranteed by the government don't have to pay as much for the money they borrow to fund their operations, giving them a competitive advantage, and they're more cavalier about risk. So they have a strong incentive to become so complex and interconnected that the government will be compelled to bail them out if they stumble again.

Geithner has announced plans to develop new rules for companies that threaten the entire financial system, and they're warranted. But it's just as important to thin the ranks of such companies. There are a number of promising ways to do so, such as imposing larger and more costly capital requirements on the financial industry giants, mandating that extra reserves be available during tough times, discouraging mergers that would create systemic risk and requiring that some of a bank's debt be convertible to stock in the event it gets into financial trouble. The system also needs more transparency so investors and regulators can see just how intertwined these companies are, and with whom. Such steps would not only reduce the potential for another collapse but would take taxpayers out of the role of the big banks' guardian angels.

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