Strong consideration is being given to disassembling large financial institutions because they are too big to fail based on the experience of the past two years. It has been argued that a financial conglomerate like Citigroup is also too large and complicated to manage, but this self-evident claim may be incorrect. If we fail to understand exactly how the crisis was allowed to occur, we risk implementing the wrong solutions that cold weaken or undermine our financial institutions.

It is utterly simplistic to argue that the credit crisis was caused by banks that were too big to fail. Neither AIG nor Fannie Mae or Freddie Mac nor Merrill Lynch nor CIT were banks. Being small did not prevent the savings and loan crisis a couple of decades ago. Being large, by itself, did not cause the credit crisis. However, a failing large institution can cause huge systemic problems, so the real question is how did some of our largest financial institutions manage to fail?

I'm old enough to remember that Continental Illinois failed and the systemic problems that followed. It was one of the largest institutions of its day, yet because of restrictive regulations that prohibited the bank from branching outside its home base in Chicago, it was unable to diversify its funding base. Allowing banks to diversify their funding sources, investment holdings and businesses spreads the risk and reduces the likelihood of failure. Indeed today, we see that many regional banks are struggling because their loans are heavily concentrated within their localities. One could easily make the argument these firms are too small to be properly diversified, even if they are not too large to fail. It is not at all obvious that a banking system comprising firms too small to be diversified would be an improvement over what we have.

The above still leaves room for the question of whether some financial institutions might be too complicated to manage. But no large institution is really run by one person. Firms are divided into businesses that are run somewhat independently, with specialists within the business and supporting infrastructure, such as HR, risk management, legal, and other support from corporate overhead. Oversight must be effective and large banks clearly failed in this key function, which argues eloquently for a review of risk management procedures and a revamp of management incentives.

The failure at the corporate level, however, was matched by a comparably serious failure at the regulatory level. Bank regulators missed or failed to act to contain excessive risk taking by banks. While this failure came to the fore with the problems at the largest financial institutions, the fallout at the smaller institutions continues, as the FDIC closes failing, smaller banks most every single weekend. This failure is a repeated performance. Regulators failed to contain excessive risk taking, self-dealing, and inadequate capital when the S&L crisis unfolded about 20 years ago. Getting rid of large banks to avoid future regulatory failures is akin to killing off all birds to avoid the spread of bird flu.

Instead of examining how regulators allowed such excessive risk taking, some politicians are using the need for change as an excuse to undermine the Fed's ability to implement monetary policy. The latest assault on the Fed's independence, if successful, will lay the seeds for the massive financial problems down the road. Politicians are too often totally irresponsible, catering to lobbyists, or focusing on the here and now benefits of their actions, while leaving the problems for future generations. The insolvency of Social Security and Medicare has been known for decades, yet Congress is unwilling to raise taxes or cut benefits to balance the books. Should politicians like Barney Frank, who pushed Fannie Mae and Freddie Mac to lend to lower income groups and then skewered them publicly for mismanaging their businesses when the loans went bad, be allowed to oversee monetary policy? Would any rise in interest rates to contain only a modest rise in inflation ever be tolerated by Congress? That is doubtful, so modest inflation would be permitted to turn into moderate inflation, which would soon evolve into higher inflation and, possibly, hyperinflation. Congressman Ron Paul's efforts to bring the Fed under Congressional oversight would be the single most glaring policy error I can imagine, even worse, potentially far worse, than Treasury Secretary Paulson's decision to permit Lehman to fail. It would be on a par with Smoot Hawley tariffs that helped precipitate the Great Depression.

Congress should be trying to understand why regulators frequently failed to rein in excessive risk taking by large banks, small banks, and nonbank financial firms. At the same time, there is also a great need to determine why regulators fail to uncover frauds on a timely basis. Despite substantial resources and numerous regulatory agencies, including the SEC, FDIC, OCC, CFTC, the Federal Reserve, state bank regulators, state insurance regulators, and others, there have been an ongoing, repeated failures in the financial system. Pursuing political agendas, such as undermining the Fed's independence from politicians, in the name of regulatory reform will only ensure new problems in the future.

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