This proposal is a recipe for increasing financial instability. The times when the Fed comes to the rescue of stricken investment banks is when the bad investments made during the most recent period of financial excess come home to roost.
The importance of this point cannot be over-emphasized: asymmetric regulation during bad times, in exchange for financial largesse by the Fed, as proposed by Treasury Secretary Paulson, is a recipe for exacerbating the financial excesses that occur during cyclical booms.
What is to be done? Clearly, the prospect of the Fed going through the books of individual investment banks and other HLFIs during goods times and bad times is not a happy one. Central planning was tried. It failed because it was not incentive-compatible. Hayek was right. So we don’t want the Fed (or anyone else) to micromanage the business strategy and investment decisions of investment banks or other HLFIs.
The US regulatory system for the financial sector is a mess. The argument that having 5 Federal agencies supervising/regulating the banking sector was a good thing because it built in redundancy (five pairs of eyes, ears and noses are better than one) turns out to be wrong. No-one was in charge. No-one was responsible. Everybody assumed the other fellow would be checking on the obvious things nobody ended up checking on. Reform and consolidation are overdue.
But the specific proposal for dealing with investment banks and other highly leveraged institutions is deeply flawed, and would end up increasing financial instability by limiting the downside during a credit bust without restraining the perceived up-side during a credit boom. The only way to prevent really bad times is to stop the good times from getting out of hand. Crude, unsophisticated credit ceilings of the kind I have outlined could do the job.