Unmet Duties in Managing Financial Safety Nets

Abstract

Officials must show that they understand why and how the public's confidence in the federal government's ability to manage financial turmoil was lost. Leaders of the Treasury, Federal Reserve, and the U.S. Securities and Exchange Commission must face up to their institutions' roles in an uncomfortable sequence of events. First, procedures adopted at private firms and federal agencies for supervising securitization activity at commercial banks, investment banks, and government-sponsored enterprises inappropriately shortcut due diligence by outsourcing the monitoring and policing of the safety-net consequences of potential defects in the securitization process to private parties. Second, when the adverse consequences of this imprudent arrangement emerged, officials falsely claimed that the difficulties that short-funded, highly leveraged firms were facing in rolling over debt reflected a shortage of market liquidity rather than a shortage of economic capital at key firms. Among knowledgeable parties, this raised severe doubts about the integrity and competence of the officials in charge of rescuing the industry. Finally, the panicky way that the Treasury and President recharacterized the nature and extent of the industry's accumulated losses in September 2008 created an extreme urgency that subsequent delays in implementation revealed to have been dangerously exaggerated. That authorities and financiers callously violated common-law duties of loyalty, competence, and care they owe taxpayers is a massive incentive breakdown in industry and government. What is needed is a thorough-going reorientation of: (1) how regulatory agencies report both on their performance and their interactions with Congress and the Administration, and (2) the contract structures and performance measures that determine how top managers and top staffers are graded and paid, not only in the financial industry but in government as well.