Testifying before Congress today, Treasury Secretary Timothy Geithner was asked about bailed-out insurance giant AIG, which received its fourth transfusion of federal funds yesterday. As Geithner explained, the reason for AIG’s extensive entanglement in the financial system is a gap in federal oversight and regulation:
AIG is a huge complex global insurance company attached to a very complicated investment bank hedge fund that was allowed to build up without any adult supervision, without adequate capital against the risks they were taking, putting your government in a terribly difficult decision. […] To allow a disorderly unwinding to happen right now in this [economic] context would cause enormous damage.
This sentiment was amplified by Federal Reserve Chairman Ben Bernanke today, who said “if there is a single episode in this entire 18 months that has made me more angry, I can’t think of one other than AIG. AIG exploited a huge gap in the regulatory system…this was a hedge fund basically that was attached to a large and stable insurance company.” And these explanations beg an important question: Going forward, what kind of adult supervision will prevent this from reoccurring?
To start, federal regulators need to abandon the idea that “growth and profitability” are valid as the sole measures of a firm’s stability. But more importantly — as Matthew Yglesias has said again and again — the very notion that financial institutions can become “too big to fail” needs to be challenged.
As Paul Volcker has said, “keep them small, so that any failure won’t have systematic importance.” Of course, we can’t just dictate a standard size, but regulation can become more stringent as a firm gets larger and more entangled. Also, implementing better capital requirements — which the Bush administration actively relaxed — will ensure that financial institutions can’t take on so much debt that they endanger the entire financial system. As Elizabeth Warren’s Congressional Oversight Panel noted in its report on regulatory reform, “the goal of enhanced capital requirements is to limit excessive risk taking during boom times and reducing the need for dangerous ‘fire sales’ during downturns.”
Incidentally, there still seems to be a lack of adult supervision at AIG. The company is reportedly keeping “four public relations firms on its payroll,” despite being kept alive by taxpayer dollars.