There's no such thing as too big to fail in a free market
The collapse of a financial ins ution is not necessarily a disaster. If free markets are to thrive, we must not allow giant, state-supported banks to believe that they are indestructible, Niall Ferguson warn
Grand illusions: there is a presumption that some big banks under threat of liquidity or solvency problems can turn to government for help
For conservatives, the financial crisis that began in the summer of 2007 has posed a major problem. We had grown rather accustomed to singing the praises of free financial markets. The crisis threatens to discredit them.
But this crisis was not the result of deregulation and market failure. In reality, it was born of a highly distorted financial market, in which excessive concentration, excessive leverage, spurious theories of risk management and, above all, moral hazard in the form of implicit state guarantees, combined to create huge ticking time-bombs on both sides of the Atlantic. The greatest danger we currently face is that the emergency measures adopted to remedy the crisis have made matters even worse.
It has often been said since the crisis began that an ins ution that is "too big to fail" (TBTF) is too big to exist. I agree. The question is how we can best get rid of the TBTFs without increasing the power of government in the economy still further. This should be among the first priorities of an incoming Conservative Chancellor of the Exchequer.
The past two decades witnessed an unprecedented concentration in the financial services sector. Between 1990 and 2008, the share of financial assets held by the 10 largest US financial ins utions rose from 10 per cent to 50 per cent, even as the number of banks fell from over 15,000 to about 8,000.
By the end of 2007, 15 megabanks, with combined shareholder equity of $857 billion, had total assets of $13.6 trillion and off-balance-sheet commitments of $5.8 trillion an aggregate leverage ratio of 23 to 1. They also had underwritten derivatives with a gross notional value of $216 trillion more than a third of the total.
This was far from being a purely American phenomenon. By 2003 the five largest banking groups in the UK accounted for 71 per cent of deposits and 75 per cent of loans.
Yet concentration in banking has not gone so far as to eliminate compe ion. On the contrary, banking remains a highly compe ive business. Indeed, it was precisely this compe ion that encouraged bank executives aggressively to pursue economies of scale, to increase leverage and to take on increasingly risky positions. To some extent, the excessive risks taken in the period leading up to 2007 can be blamed on defective mathematical models. However, another explanation is that big financial ins utions had reason to believe that they enjoy a privileged and in some measure protected position.
Economists have long held that bank failures pose a "systemic" economic risk, because failed banks are associated with monetary contractions for the economy as a whole. There is therefore a presumption that, if big banks are threatened with liquidity or solvency problems, they should be bailed out by the action of the central bank or government. Despite much pious talk of "moral hazard" prior to 2007, little was done to disabuse big financial ins utions of this notion. They could and did assume that they enjoyed an implicit government guarantee.
With the exception of Lehman Brothers, they were right. Beginning with the British Government's takeover of Northern Rock in 2007 and culminating in the US Government's vast injections of capital into AIG, Citigroup and other ins utions, the Western world has witnessed a succession of government interventions in the banking system unprecedented other than in time of war. These measures can be justified on the ground that without them there would have been a banking crisis comparable with that of 1931, which did as much as the 1929 stock market crash to plunge the world into a Great Depression.
But there is a danger that justified emergency measures give rise to unjustifiable permanent conditions.
What happened last year provided a belated vindication for one of the central tenets of Marxism-Leninism: that increasing concentration of financial capital would lead ultimately to crisis, followed by the socialisation of the banking system. This was the basis for the concept of "state monopoly capitalism".
The crisis brought "stamokap" several steps closer in two ways. First, it wiped out three of the biggest US banks Bear, Merrill, and Lehman while at the same time condemning more than 140 (and still counting) smaller regional and local banks to oblivion. Second, because the failure of Lehman was so economically disastrous, it established what had previously only been suspected that the survivors were Too Big To Fail.
This is moral hazard run mad a system in which a few giant banks get to operate as hedge funds with a government guarantee that if they blow up, their losses will be socialised.
Few of the regulatory reforms proposed so far do enough to solve the central problem of the TBTFs. Consider what US Treasury Secretary Geithner proposed in his Congressional testimony of September 23:
There will be a new National Bank Supervisor. However, responsibility for regulating the TBTFs will lie elsewhere, by implication with the Federal Reserve or the Treasury.
The administration intends to "tighten constraints on leverage by requiring that all financial firms hold higher capital and liquidity buffers". But TBTFs will be asked to do more, in at least two respects. First, they will be asked to prepare "living wills" plans for how they should be "dismantled in case of failure". Second, they will also be subject to "very strong government oversight".
Are these measures sufficient? Britain's Labour Government apparently thinks they go too far. Speaking in the House of Commons on July 8, the Chancellor of the Exchequer declared that he feared "the consequences of telling a large bank that it is too big. In response to that, the bank might say, 'We're too big, so we'll go somewhere else.' "
Although prepared to countenance tighter regulation for big financial ins utions, the Government made it clear in its White Paper of the same date that it was "not persuaded that artificial limits should be placed on firms to restrict their size or complexity".
By contrast, some continental European governments, notably the French and the German, would like to go further than the Geithner proposals. In particular, the egalitarian-minded continentals are itching to impose some kind of international cap on bankers' compensation. Another idea, floated by the head of the UK Financial Services Authority, Lord Turner, is to levy a tax on all financial transactions.
Then there are those traditionalists who would like to see a return to the separation of commercial banking and investment banking along the lines of the old Glass-Steagall Act. A case could also be made for tightening anti-trust rules for the financial services sector; this is roughly the position of the EU Commissioner Neelie Kroes. Finally, a few economists on both sides of the Atlantic have begun arguing for "narrow" or "limited purpose" banking, which would limit the ability of deposit-taking ins utions to engage in risky business.
There is, however, a danger that the essential goal the euthanasia of the TBTFs will vanish from sight as the number of proposals increases. So let us dismiss the various red herrings. The headline-grabbing compensation issue, it should be noted, is the reddest of the lot. Million-dollar bonuses are a symptom, not a cause, of the deeper malaise. Almost as red a herring is the Turner tax. Raising transaction costs in the financial sector would help rather than hinder the TBTFs. It would be the biggest firms, exploiting economies of scale, that could most easily cope with such a change.
Also a herring, though more pink in hue, is Secretary Geithner's pledge to regulate the TBTFs more tightly. It is impossible to be impressed by such pledges when it was the most regulated ins utions in the financial system that were among the most disaster-prone. The old Latin question is apposite here: quis custodiet ipsos custodes? Who regulates the regulators?
The most appealing fish on offer but still a herring is the idea of "narrow" banking. The problem with this is that it would turn the clock back not to the 1930s but to the 1650s to the period before fractional reserve banking began to spread through the Western world. I remain unpersuaded that we need to jettison so much of what financial evolution has achieved over three and a half centuries, especially since two of the most systemically dangerous firms in the crisis were not deposit-taking ins utions.
There is, in fact, one simple insight, buried in Secretary Geithner's testimony, upon which we need to build. As he clearly understands, the real aim of government should be to give the TBTFs "positive incentives to shrink and to reduce their leverage, complexity, and interconnectedness".
The best way of creating such incentives is to reiterate, preferably once a week, one key point: in case of failure, "the largest, most interconnected firms" should in future be wound up "in a way that protects taxpayers and the broader economy while ensuring that losses are borne by creditors and other stakeholders".
That was the principle that was thrown overboard in the crisis, when it was decided to prevent the holders of bank bonds (apart from those of Lehman Brothers) from losing their money. Removing that protection will necessarily raise the cost of credit for the TBTFs, reduce their profitability and encourage them to split themselves up.
During the crisis it was often said that officials at the Federal Reserve and Treasury would do "whatever it takes" to avoid a Great Depression. Now they must do whatever it takes to address one of the key causes of the financial crisis: the existence of financial ins utions that consider themselves too big to fail but which are run in such a way that they are bound to do so.
Not a terrible article, but the segment above is what gets me. HOW?The best way of creating such incentives is to reiterate, preferably once a week, one key point: in case of failure, "the largest, most interconnected firms" should in future be wound up "in a way that protects taxpayers and the broader economy while ensuring that losses are borne by creditors and other stakeholders".
Like the FDIC does with banks, or did when it created the RTC.
coyotes_geek has suggested anti-trust action and bankruptcy courts as possibilities.
I assume that this is your answer to a question posed in another thread, i.e., how would you accomplish the dismantling of the TBTFs.
I happened to be on the Board of Directors of a Bank before the regulatory mechanism allowed deposit banks to also provide investment banking services along with checking and savings and deposits (this was in the early 90's). I remember all of us being very unhappy that the bank was limited in its functions, and very thrilled when the law changed. Then every bank in American started gobbling up all the smaller banks, and we all cheered wildly because A) as stockholders in a smaller regional bank we were poised to make out like bandits in the merger mania that ensued, and B) it was closer to 'unfettered' capitalism that we all believed would be the salvation of mankind.
The point here, I believe, is that this stuff is cyclical, and there is no silver bullet of regulation or deregulation that can guarantee that what happened will not happen again. Eventually.
"can guarantee that what happened will not happen again"
Glass-Steagal, etc, kept the financial system stable and boring since the 1930s, all through the fantastic growth in real wealth after WWII up to Viet Nam.
It's only when the Repugs/conservatives starting deregulation in the early 1980s, that financial system became unboring, and risky. Boom! the S&L disaster.
Because the financial system and corps OWN Congress, both parties, serious, save-our-asses re-regulation simply won't happen.
There is already a bubble coming with Wall St buying up life insurance policies and bundling them off into ownership by capitalists to cash them in.
I disagree with some of the article, but completely agree with the opening paragraph.
way to jump over the 70's.
Problem is, this is just a natural result of the banking system we have.
Be nice if people would take this one step further...and let govt fail and go into reorganization...financially. If it thinks it's too big to fail financially, nothing stops it from doing what it's been doing...just spend more.
Next time they ask you for more money...just say no.
Guarantee? No.
In your mind what could be done to mitigate/manage the risks of banking?
Surely we can manage the system better than we do now.
If we can't, we're screwed.
I think we may be screwed.
Supposing there is a slight chance we are not completely screwed yet, what would be prudent to do?
I don't mean to be flip. I honestly don't know how to fix any of this crap that is going on now.
The regulatory framework that Boutons referred to was, in fact, what kept the banking industry boring, and kept Republican politicians claiming that the market would 'regulate itself' if the regulators would just get out of the way.
Well, sometimes regulation is worthwhile. I think the financial system is one area where regulation would be good. Having said that, though, there is no way that the regulations necessary to do the job would be considered anything other than 'socialism'. I don't think Obama is anywhere near being ready to take on that fight.
Look at what is happening today. The market is overheated right now, in much the same it was absurdly tanked last fall and winter. It was WAY oversold last fall and winter, based mostly on psychology, and it has moved up too fast (maybe not too far, given leading economic indicators, but certainly too fast). There will always be arbitrage opportunities in the financial markets, and there will always be arbitrage opportunities in regulatory frameworks. Bankers will figure a way around things, or they will buy the politicians necessary to change the regulations.
The folks who control the markets today are the at ude-movers (not unlike the media) who write up stuff (true or not) about this or that company and then short the stock (watching the shmucks like us try to get out of it before it completely tanks) or the market itself (as happened last fall), make a mint, then exit laughing.
Look at how little coverage this sort of real debate gets in either the left-wing or the right-wing media. This is stuff of policy, and politicians don't get elected on things like this. They get elected based on what people are most afraid of at that moment in time (like too long a war or too many taxes or too much government incompetence, or whatever). So I don't have high hopes.
Sorry.
Why not left the bankers and their shareholders to worry about that? It's their money, they're the ones with the biggest incentives to minimize risks. Why do "we" need to manage a system?
Otherwise, the only "prudent approach" is to get rid of the fiat money, by changing the tender laws.
Having said all of that, I generally believe that Ferguson is right.
I think that the leverage requirements are the most important piece, ( I mean a balance sheet is a balance sheet, you know...banks shouldn't be held to a lower standard than Joe's plumbing company) but the guy who said that if we require that, they will just say 'we will take our business elsewhere' has clearly been in contact with American bankers. Because they WILL go overseas, wherever the regulations are more tolerable ( the regulatory arbitrage thing), and then whatever political party was responsible for the regulation will be blamed for losing all of that capital, and on and on and on.
We'll see. It's needful. The status quo ante wasn't perfect, it made banking boring, but it was a pretty good system for about 60 years.
Buy on the rumor, sell on the news.
Look on the bright side: there could be a stumble -- or something worse -- on the way to recovery that will get everyone focused on the problem again. But I agree that if the problem isn't immediately in front of people, attention goes away.Look at how little coverage this sort of real debate gets in either the left-wing or the right-wing media. This is stuff of policy, and politicians don't get elected on things like this. They get elected based on what people are most afraid of at that moment in time (like too long a war or too many taxes or too much government incompetence, or whatever). So I don't have high hopes.
The door for business reform already appears to be closing. IMO Obama should have tackled this before health care.
Now that is something I definitely agree with. I think that he didn't because Geithner, Summers, etc. are as committed to free markets as anyone else. I honestly think they believe that if they wait long enough, the ship will 'right' itself.
Because we just hocked our future productivity to pull their bacon out of the fire and we can't afford to do it again.
The government backstop is still in place. It needs to be removed.
I agree, but monetary reform is even more of a long shot than business reform. Maybe another financial panic -- or a series of them -- will make this solution credible again. for now, it's beyond the political pale.
But at least people are starting to talk about it. That's something.
Also, HB 1207 now has 290 co-sponsors and S 604 has 30. Another, possibly encouraging sign.
Just remove it and stick to it. The reason why TBTF exist in the first place is because there's an implicit understanding that the government sees them as TBTF. As Fergunson says, remove that incentive and TBTF will cease to exist.
I agree about the lack of feasibility in the near future for monetary reform. I don't think any other kind of regulation will make much of a difference though.
I would think the obvious answer is because they f'd it up to such a giant degree that we were forced to do one of two things:
1) Get the American taxpayer to pay off the bail
2) Let the economy contract and go through a series of layoffs, company closures and destruction of wealth
Additionally, there can be a real information asymetry for shareholders. Bankers can (fraudulently) cook the books, claim nothing is wrong, and skate out, leaving the shareholders with the bill.
The Gramm-Leach-Bliley act undid Glass-Steagal. Senate dems voted 38-7 in favor. House dems supported it 155-51. A democratic president signed it.
Even Garn-St. Germain which deregulated the S&L's back in 1982 made it through a house of representatives where democrats had a 50+ seat advantage over the republicans.
Deregulation happened because both parties wanted it. Of course that fact conveniently gets ignored by the blue team puppets who are trying to use revisionist history to put all the blame on republicans.
This makes it seem as though the only reason corporations are that large is because they want the protection of government bailouts and that simply ins't the case. There are plenty of reasons for corporations to want to become that large even with the risk of failure.
Removing it sounds fabulous in theory, but the fact is that corporations would still become quite large and would still endanger our economy. Its also easy to say that we should all ignore the shareholders and let them take the loss but the fact is the ramifications of actions of that nature extend much further than simply to those who own the stock.
That can happens with any corporation.
Remember ENRON?
There are currently 1 users browsing this thread. (0 members and 1 guests)
Posting Permissions
Reply With Quote
