Volcker: Financial bailout could make next crisis worse

Former Fed Chair Paul Volcker says the problem is ‘moral hazard’ – policies leading investors and bankers to believe they can take future risks without bearing the full cost.

By , Staff writer

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    Former Federal Reserve Bank Chairman, and current White House economic adviser, Paul Volcker testifies on Capitol Hill in Washington on Thursday, before the House Financial Services Committee hearing.
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The federal government's massive bailout of Wall Street in the past year may have solved one problem while creating another: the risk that the next financial crisis will be even deeper.

That's what finance experts told House lawmakers at a hearing Thursday, as Congress considers sweeping regulatory reforms.

The Obama administration has proposed its version of financial reform. But at Thursday's hearing of the House Financial Services Committee, both lawmakers and expert witnesses wondered aloud whether the measures will work.

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"I'm afraid there's a real danger," said Paul Volcker, former chairman of the Federal Reserve, even as he expressed support for much of the Obama plan.

The problem is an age-old dilemma known as "moral hazard."

Getting out of a crisis is often achieved through bailouts. But that very action makes investors and bankers believe that they can take future risks without bearing the full cost.

"The danger is that the spread of … moral hazard will make the next crisis bigger," Mr. Volcker said, agreeing with a worried lawmaker.

When financial firms become so powerful that they are considered "too big to fail," then policymakers tend to offer at least partial rescues of firms and their creditors during a crisis. Last year, giants such as Lehman Brothers and Washington Mutual failed, but others were supported mightily by federal relief. Creditors of banks were bailed out, while bond holders in nonfinancial firms generally face losses in bankruptcy.

Even the rescue’s architects, current Fed Chairman Ben Bernanke and Treasury Secretary Timothy Geithner, acknowledge the risk that moral hazard has increased as a result of the past year's actions.

At the core of Obama's reform plan is a "resolution authority" so that large firms could enter an orderly wind-down, akin to bankruptcy, under the wing of regulators. This would be a middle ground between the costly bailout provided for the insurer AIG and Lehman's collapse into a slower and more chaotic court-managed bankruptcy.

But the law doesn't mandate that failing firms be wound down. It also provides options for regulators to provide emergency assistance.

Many economists say it’s useful for regulators to have flexibility. But critics say it raises the question of whether the Obama plan will do anything to end the cycle of bailouts, private-sector risk-taking, and larger crises.

The question spans across party lines.

Rep. Brad Sherman (D) of California was among those concerned the Obama plan would allow Treasury to conduct bailouts without a direct congressional appropriation of funds. "The Constitution calls for votes on the floor … where even bald guys from California get to vote," he said.

The House panel heard experts with contrasting views. Mark Zandi of Moody's Economy.com cautioned against a no-more-bailouts approach to controlling risk in the financial sector. "We saw pretty clearly" with Lehman, he said, the problems with allowing systemically important firms to go bankrupt.

Jeffrey Miron of Harvard University argued that some form of failure must be allowed, or risk-taking and crises will only grow worse. It's true, he said, that bankruptcy at one firm would have adverse ripple effects for firms dealing with it. But allowing failures would prod the industry to scale back on such counterparty risk. "It’s not going to start happening until we actually stick it to somebody," Mr. Miron said.

Rep. Al Green (D) of Texas may have spoken for many committee members when he said bailouts should never happen again, but then asked: "God forbid, if we have to, how do we do it?"

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