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Staving off a meltdown

The bailout of the giant insurer American Insurance Group by the U.S. Federal Reserve is significant for its magnitude and timing. AIG stands to get up to $85 billion by way of emergency funding in return for handing over effective control. Even while the fate of Lehman Brothers and Merrill Lynch was hanging in the balance, the spotlight had turned on AIG, whose desperate financial predicament was becoming clearer by the day. Last weekend Lehman filed for bankruptcy and Me rrill was sold off to Bank of America. These two developments have had major implications both for the U.S. and the rest of the world, with some of them becoming clear only gradually. The policy responses to the imminent failures of these institutions have been different. Lehman was allowed to go bankrupt. The takeover of Merrill was not engineered by the U.S. Treasury, the way Bear Stearns’s was six months earlier. The rescue of AIG has more in common with the virtual nationalisation of the two big mortgage lenders, Fannie Mae and Freddie Mac. The obvious inference is that, like those two institutions, AIG is too big and too important to be allowed to go under without aggravating the already considerable damage the real economy has suffered in the wake of the financial sector crisis. However, while staving off a financial meltdown that a collapse of AIG would have caused, the U.S. policy-makers might be heightening the moral hazard. Bailing out financial institutions that have acted recklessly will encourage similar behaviour by other institutions. In any case, there is a limit up to which taxpayers can subsidise a failing institution.

The choice between preventing a systemic failure and allowing major institutions to be punished by the merciless markets is a difficult one. However, even in the U.S., there have been instances of the government stepping in as, for example, in the case of Long Term Capital Management in 1998. AIG’s failure would have adversely affected other businesses, whose risks it has insured. Very often, public authorities seem to go by the overall impact of allowing even institutions that have been reckless to go under. One lesson that emerges is that a much greater degree of co-ordination and cooperation is necessary among the different regulators worldwide. Just two of the five principal investment banks have survived the turmoil of the last six months. The highly fragmented financial sector regulatory mechanism will have to be revamped. The advent of financial “supermarkets” has exposed the average bank to risks on many fronts. The need for a super-regulator was felt even earlier but has now gained urgency.

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