Today The Wall Street Journal runs an article titled, Citi Management Gets Generally Good Review. The Journal reports that an “outside review of Citigroup Inc.’s management team has concluded that it is generally in good shape,” and explains:

The review, conducted this summer for Citigroup’s board by recruiting and consulting firm Egon Zehnder International, was triggered by the government’s stress tests of top banks last spring. Companies found to need more capital were required to conduct assessments of their management and report the findings to federal regulators.

This evaluation of Citigroup’s management is an indicator of how lack of accountability ultimately permeates any system that acknowledges firms are too big to fail.

In my book on practical entrepreneurship, one of the points I made was that when you go out on your own, as every small business person knows, there “is no grade of A for effort,” or particularly rewards for poor results that reflect “events beyond your control.” When you run a smaller company, it does not matter how talented you are, how manifestly brilliant your plan is, or even if a totally unforeseeable, once in three decades hurricane, wipes out the total stock in your warehouse: If expenses exceed cash flow, the business fails and you are out of a job.

Similarly, the question of whether Citigroup has talented leadership is irrelevant. I suspect that the CEO is brilliant. However, by definition, the leadership of the bank performed poorly. The bank leadership, made decisions with negative ramifications that are almost unimaginable. The bank performed so poorly that it’s failure cost the taxpayers billions of dollars and required the government to put the institution on life-support. Moreover, this was all done because management performed so poorly hat it not only imperiled the bank but the entire financial system of the nation. Now, a Bloomberg survey, predicts that Citigroup will report a 2.6 billion loss for the third quarter, even as many other financial institutions have stopped bleeding.

In these circumstances, it seems inappropriate to even inquire about the managerial talent of the bank’s management. In any situation where market forces prevailed, the corporation would no longer exist, because of management’s poor decisions.

What’s particularly concerning here is that this type of report is probably a harbinger of what will happen if we adopt the Treasury Department’s proposed “too big to fail” plan. Under the currently proposed reform plan, our increasingly concentrated financial system will remain in place with additional regulations and the requirement that every firm maintain up-to-date plans for its dismantling should it fail. Let’s look at the reality of a situation where the government is confronted by a large firm, that has taken excessive risks, and should now be accountable for its action:

1.) The situation confronting the federal government will look eerily like the events surrounding Citigroup today.

2.) By definition, the potential failure will have been caused by something unforeseen by regulators or management. Otherwise, it will not have occurred.

3.) Since it was not foreseeable, management (and probably regulators) will shun accountability. This aspect of the culture of our financial system and the behavior of regulators is one lesson of today’s crisis.

4.) The threatened entity will argue that — despite the in-place plans for unwinding required under the proposed Treasury legislation– recent developments demonstrate that no one really understands the consequences of the interconnections in the system. In addition, as vividly demonstrated in the failure of AIG, the institutions that will be affected by this failure will add to this chorus of voices calling for government intervention.

In testifying before the Joint Economic Committee of Congress last April, Nobel laureate Joseph Stiglitz put it this way:

“Before a crisis, every financial institution will claim that it does not pose systemic risk; in a crisis, almost all (and those that would be affected by a collapse) will make such claims.”

5.) The financial industry, aided by its well-documented political influence, will rally to argue that regulators risk further harm to the economy and the total financial system by shutting down the institution.

Under these circumstances, what are the odds that accountability will be enforced and the otherwise bankrupt institution will be closed? Perhaps 10%.

6.) So, the government will ultimately prevent this too large institution from failing and our economy will grow even weaker, as these institutions further distort the efficient allocation of capital, engage in high risk activities because of moral hazard, maintain pay scales unrelated to their actual profitability, and through their size and implicit (or explicit) government subsidies stifle competition and distort the market for their services.

Critics of this argument will correctly point out that the Treasury plan also mandates multiple new safeguards to create a less risky financial system. This is true, and these reforms are unquestionably valuable. However, they cannot be enough. The modern history of finance, combined with ever advancing technology, clearly shows that the locus of the next crisis is not predictable. We will always be regulating to prevent the causes of yesterday’s failure.

Sheila Blair, the head of the FDIC, recently argued that the doctrine of “too big to fail” must end. According to The New York Tines, in speaking to a meeting of the Institute for International Finance, she said:

“I believe that the new regime should apply to all bank holding companies that are more than just shells and their affiliates, regardless or not whether they are considered to be systemic risks,”

Yes, all entities must be accountable for their results and subject to shut-down. However, as suggested above, government authority is pointless when potential systematic risk is permitted to exist. When the moment of decision comes, this shut-down authority will never be exercised.

Last week, as part of the New Deal 2.0 blog of the Roosevelt Institute, I argued that we needed smaller financial institutions, whose failure could occur unimpeded by the government, without creating a risk to the overall economy. This will require enormous political will, and is the kind of hard decision that we must not avoid.

One of the reasons the reforms of the Roosevelt Administration stabilized the nation’s banking system for almost a century was that it did not shrink from such hard choices. In last week’s article, I pointed out that then, as now, the choice was between large super-financial institutions (favored by the industry) and mandating smaller, focused entities — as ultimately required by Glass-Steagall. New Deal efforts succeeded because FDR and his Administration did not shrink from making this hard decision and fighting to bring it to life. Ultimately, market-based failures are the only way to ensure accountability. Today’s Citigroup report shows how easy it becomes, once market judgments are removed, to prevent the disciplines that govern all of the other sectors of the economy.

This is not an argument that Glass-Steagall in its original form would have prevented the current crisis. Rather, it is an argument that the principles of Glass-Steagall provide a valuable guide for how we could reform today’s system. By separating companies according to lines of business, the nation gains the following advantages:

A more robust financial system. Different types of entities (commercial banks, underwriters, insurers) would all be pursuing different business models. In this diverse marketplace, they would be unlikely to follow the lemming-like strategies that made the entire system so vulnerable to securitized mortgages, or whatever becomes the popular product-of-the-moment.

This combination of smaller institutions, pursuing divers profit-making strategies, will dramatically decrease the potential that the failure of any one firm will create a systematic risk to the financial system.

Capital would be allocated more appropriately. The efficient allocation of capital is the ultimate purpose of our financial sector, so this benefit should weigh heavily, if not absolutely, in our thinking. As entities focus on specific aspects of financial activity, capital would flow to them, and be allocated in the larger society more efficiently. We have witnessed how larger entities have systematically allocated capital to high risk activities (often with zero-sum benefits for society),and failed in this fundamental mission.

Less distorting market power in the financial sector. No one believes its good for the government to be involved in setting executive wages. One reason this has happened is because the largest financial institutions lack effective competition, so profits (or perceived profits or industry norms resulting from excess profits) have permitted pay to skyrocket. Greater competition, which becomes possible as existing entities decrease in size, has the potential to lower the market distorting advantages of the largest firms. Over time, in this more competitive market without government subsidies, the excess profits now going into executive pay would disappear.

A less fragile financial system. More is better. Any system that is dependent on a limited number of entities or components is inherently weak. Whenever possible, NASA create a backup capability in space crafts on the assumption that individual systems will fail–no matter how carefully they are checked — and this creates an unacceptable risk.

The benefits of competition. Effective competition creates innovation, new approaches to business problems, innovative services, and a generally healthier, more dynamic system. America desperately needs that kind of customer-focused creative, innovation in our financial system today.

Better regulatory oversight. Do we really believe that in the future regulators will be able to understand the risk dynamics of our huge financial entities? Smaller, focused entities have fewer moving parts and require less expertise in multiple arenas. To the extent the nation needs effective regulation, it’s far more likely to occur under these circumstances.

Decreased political power that distorts markets. Wealth inevitably leads to the accumulation of political power. This power is inevitably used to protect entrenched interests. One of the strengths of America has always been that we are a land where many voices are heard. In a more diverse financial system, different participants are likely to have different viewpoints, and I would argue that the political influence of a few large entities is inherently higher than the sum power exercised by a diverse industry.

Last week’s article on the principles of Glass-Steagall received a number of valuable comments. Many raised important suggestions and valid criticisms. However, I was nonetheless left with one lingering question: What did the authors of the comments specifically suggest we should do?

We all know moral hazard is a problem. We know too big to fail is a problem. To it’s credit, the Treasury has proposed one solution. I have proposed the outlines of another, because I cannot see a workable alternative to a break-up of financial firms. At the Joint Economic Committee hearing, Stiglitz argued for a breakup modeled on a Glass-Steagall model, saying,

“We have little to lose, and much to gain, by breaking up these behemoths, which are not just too big to fail, but also too big to save and too big to manage,”

In a similar spirit, MIT economist Simon Johnston argued for revising the antitrust laws thereby requiring a break-up based on regional size or type of business. Right now, we need to solve this big question: Should some version of the Treasury plan be adopted or should the nation mandate some form of break-up. Last week’s article led to many comments that said, in effect, “I agree that the Treasury proposal will not work but I don’t know that we need to break up the banks.”

So, here’s the challenge, and the nation desperately needs an answer. If you disagree with the Treasury plan, and you disagree that the banks should be broken-up, what specifically should we do?

(This post originally appeared at the author's blog)

