There are two key elements to fixing Wall Street:
- Raising capital requirements (so firms can take less risk)
- Creating special bankruptcy rules so stupid firms can fail without bringing down the system.
To be clear, we’re not talking about a Lehman-type all-hell-breaks-loose failure. We’re not talking about years in bankruptcy court. We’re talking about simple rules that trigger an automatic recapitalization of the company overnight by converting debt to equity.
At the same time, management would be tossed, and the cash bonus pool would be zeroed until the company returned to profitability.
This way, you get the government bureaucrats out of the details, but you also let stupid firms fail without taking down the whole system.
Arthur Levitt, former Chairman of the SEC (and a Goldman advisor), agrees:
But while better regulation would have helped avert some of the crisis, there is no guarantee that regulators can avoid a similar crisis in the future. We must address the lack of an orderly process for the demise of large financial institutions. Before last year, we were all aware of “moral hazard” and what it meant – we just did not know it referred to far greater swaths of the financial markets.
So in the unique series of events that started with the fall of Bear Stearns, there was no way to deliver an orderly lesson on the danger of moral hazard. As a result, investors, lenders and management could believe, in almost every case, their institutions were “too big to fail”.
To avoid another crisis we must address this flaw in our regulatory system. We need a process that is known in advance, includes the efficient and orderly write-down of assets and restructuring of debt, and draws on public funds only as a last resort. We need a resolution authority created explicitly to impose discipline on those with the most power to influence the level of risk-taking: the holders of both equity and debt of institutions that may be “too big to fail.”…
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