A dagger at the heart of business: why business should be wary of the financial Services Oversight Council.

Author:Epstein, Richard

This first year of the Obama administration has been marked by its relentless pursuit of major regulatory initiatives on a full range of domestic issues. CEOs who find it difficult to implement one program at a time must wonder how a president unversed in complex business issues can push forward simultaneously on four major fronts: healthcare, global warming, labor law and, last but not least, financial regulation.

The Reform Agenda

Real work is needed in each of these areas. But sound reform should not make matters worse, which is what will happen to the financial sector if Congress passes the misnamed Financial Stability Improvement Act. The FSIA would create a stronger federal presence under a newly created Financil Services Oversight Council, allegedly to cope with any repetition of the financial meltdown of the fall of 2008. The case for the FSIA rests on a single proposition: The government must be equipped to deal with systemic risk.

Systemic risk is, of course, just a fancy term for the positive correlation in the failure of major financial institutions: Once one domino topples, others will quickly follow, bringing a heavily interlinked financial system to its knees. This systemic risk is a modern rendition of yesterday's "run on the bank," Old-line banks can only work by lending out most of their deposits at rates than they pay to their depositors. Making these loans necessarily means that banks cannot keep all their assets in cash or cash equivalents even though all depositors have the unfettered right to withdraw their money at any time. In stable times, happy customers deposit and withdraw money independently in accordance with their personal needs, so that the limited amounts of cash in the till can meet all demands on the bank. Tranquility reins.

However, once it is feared, or rumored, that the bank is about to fail, all depositors rush to demand payment at once. The inability of even a solvent bank instantly to convert its long-term loans to cash could create a short-term calamity. Government insurance helps counter that risk in two ways. First, it picks up the financial slack for depositors when the banks fail. Second, by giving depositors confidence it nips any possible bank run in the bud.

This federal insurance is not, however, a free good. The risk, of course, is that banks will make foolish loans because they look more to the government guarantee than the sufficiency of the debtor's collateral. No private insurer would...

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