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Thursday, September 02, 2010

"Too Much “Too Big to Fail”?"

Adair Turner, Chairman of Britain’s Financial Services Authority, on the too big to fail problem:

Too Much “Too Big to Fail”?, by Adair Turner, Commentary, Project Syndicate: Obviously, the global financial crisis of 2008-2009 was partly one of specific, systemically important banks and other financial institutions such as AIG. In response, there is an intense debate about the problems caused when such institutions are said to be “too big to fail.”
Politically, that debate focuses on the costs of bailouts and on tax schemes designed to “get our money back.” For economists, the debate focuses on the moral hazard created by ex ante expectations of a bailout, which reduce market discipline on excessive risk-taking – as well as on the unfair advantage that such implicit guarantees give to large players over their small-enough-to-fail competitors.
Numerous policy options to deal with this problem are now being debated. These include higher capital ratios for systemically important banks, stricter supervision, limits on trading activity, pre-designated resolution and recovery plans, and taxes aimed not at “getting our money back,” but at internalizing externalities – that is, making those at fault pay the social costs of their behavior – and creating better incentives.
I am convinced that finding answers to the too-big-to-fail problem is necessary... But we must not confuse “necessary” with “sufficient”; there is a danger that an exclusive focus on institutions that are too big to fail could divert us from more fundamental issues.
In the public’s eyes, the focus on such institutions appears justified by the huge costs of financial rescue. But when we look back on this crisis in, say, ten years, what may be striking is how small the direct costs of rescue will appear. Many government funding guarantees will turn out to have been costless...
All of this implies that the crucial problem is not the fiscal cost of rescue, but the macroeconomic volatility induced by precarious credit supply – first provided too easily and at too low a price, and then severely restricted. And it is possible – indeed, I suspect likely – that such credit-supply problems would exist even if the too-big-to-fail problem were effectively addressed. ...
There is therefore a danger that excessive focus on “too big to fail” could become a new form of the belief that if only we could identify and correct some crucial market failure, we would, at last, achieve a stable and self-equilibrating system. Many of the problems that led to the crisis – and that could give rise to future crises if left unaddressed – originated elsewhere.

I mostly oppose large banks due to the political power that they have, the market power that comes with size, the unfair advantage the implicit guarantee of a bailout gives large banks over small banks (since the large banks are perceived as less risky due to the guarantee, they can get funds at a lower cost), and the fact that the implicit guarantee induces large banks to take on too much risk. There's also a worry that size and connectedness amplifies the effects of a crisis. However, I don't think systemic risk falls much by simply breaking the banks into smaller pieces, so this isn't a major part of the reason why I think we should limit bank size. There are plenty of examples of crises involving smaller banks in the U.S. and elsewhere, so breaking banks up does not provide an impermeable defense against systemic issues.

The most frustrating part, though, is the implicit assumption in most of these discussions that big banks are inevitable. I have yet to see an analysis that convinces me that large banks provide a boost to efficiency that more than compensates for the problems their size brings about. I realize we are reluctant to impose per se rules against size for good reason, and that the fact that they may not increase efficiency is not sufficient justification to break them up, but the political power, the excessive risk taking, the economic power that come with size, etc. are. Maybe the problems aren't as large or worrisome as I believe, but it would be nice to have the sense that regulators are at least asking these questions. Instead they seem to be resigned to the fact that large banks are inevitable.

I hope to do more with this speech later -- we'll see if time permits that -- but here's Ben Bernanke talking about this issue earlier today: Notice the assumption in the background that large banks will exist:

"Too Big to Fail"
Many of the vulnerabilities that amplified the crisis are linked with the problem of so-called too-big-to-fail firms. A too-big-to-fail firm is one whose size, complexity, interconnectedness, and critical functions are such that, should the firm go unexpectedly into liquidation, the rest of the financial system and the economy would face severe adverse consequences. Governments provide support to too-big-to-fail firms in a crisis not out of favoritism or particular concern for the management, owners, or creditors of the firm, but because they recognize that the consequences for the broader economy of allowing a disorderly failure greatly outweigh the costs of avoiding the failure in some way. ...
In the midst of the crisis, providing support to a too-big-to-fail firm usually represents the best of bad alternatives; without such support there could be substantial damage to the economy. However, the existence of too-big-to-fail firms creates several problems in the long run.
First, too-big-to-fail generates a severe moral hazard. If creditors believe that an institution will not be allowed to fail, they will not demand as much compensation for risks as they otherwise would, thus weakening market discipline; nor will they invest as many resources in monitoring the firm's risk-taking. As a result, too-big-to-fail firms will tend to take more risk than desirable, in the expectation that they will receive assistance if their bets go bad. Where they have the necessary authority, regulators will try to limit that risk-taking, but without the help of market discipline they will find it difficult to do so... There is little doubt that excessive risk-taking by too-big-to-fail firms significantly contributed to the crisis...
A second cost of too-big-to-fail is that it creates an uneven playing field between big and small firms. This unfair competition, together with the incentive to grow that too-big-to-fail provides, increases risk and artificially raises the market share of too-big-to-fail firms, to the detriment of economic efficiency as well as financial stability.
Third, as we saw in 2008 and 2009, too-big-to-fail firms can themselves become major risks to overall financial stability, particularly in the absence of adequate resolution tools. ... The failures of smaller, less interconnected firms, though certainly of significant concern, have not had substantial effects on the stability of the financial system as a whole.
If the crisis has a single lesson, it is that the too-big-to-fail problem must be solved. Simple declarations that the government will not assist firms in the future, or restrictions that make providing assistance more difficult, will not be credible on their own. Few governments will accept devastating economic costs if a rescue can be conducted at a lesser cost; even if one Administration refrained from rescuing a large, complex firm, market participants would believe that others might not refrain in the future. Thus, a promise not to intervene in and of itself will not solve the problem.
The new financial reform law and current negotiations on new Basel capital and liquidity regulations have together set into motion a three-part strategy to address too-big-to-fail. First, the propensity for excessive risk-taking by large, complex, interconnected firms must be greatly reduced. Among the tools that will be used to achieve this goal are more-rigorous capital and liquidity requirements, including higher standards for systemically critical firms; tougher regulation and supervision of the largest firms, including restrictions on activities and on the structure of compensation packages; and measures to increase transparency and market discipline. Oversight of the largest firms must take into account not only their own safety and soundness, but also the systemic risks they pose.
Second, as I already discussed, a resolution regime is being implemented that allows the government to resolve a distressed, systemically important financial firm in a fashion that avoids disorderly liquidation while imposing losses on creditors and shareholders. Ensuring that that new regime is workable and credible will be a critical challenge for regulators.

Finally, the more resilient the financial system, the less the cost of a failure of a large firm, and thus the less incentive the government has to prevent that failure. Examples of policies to increase resiliency include the requirements in the recent bill to force more derivatives settlement into clearinghouses and to strengthen the prudential oversight of key financial market utilities such as clearinghouses and exchanges. ... In addition, prudential regulators should take actions to reduce systemic risks. Examples include requiring firms to have less-complex corporate structures that make effective resolution of a failing firm easier, and requiring clearing and settlement procedures that reduce vulnerable interconnections among firms.

I asked Bernanke if large banks are necessary. Here's what he said:

B. Mark Thoma, University of Oregon and blogger: ...The proposed regulatory structure seems to take as given that large, potentially systemically important firms will exist, hence, the call for ready, on the shelf plans for the dissolution of such firms and for the authority to dissolve them. Why are large firms necessary? Would breaking them up reduce risk?
...Although regulators can do a great deal on their own to improve financial regulation and oversight, the Congress also must act to address the extremely serious problem posed by firms perceived as “too big to fail.” Legislative action is needed to create new mechanisms for oversight of the financial system as a whole. Two important elements would be to subject all systemically important financial firms to effective consolidated supervision and to establish procedures for winding down a failing, systemically critical institution to avoid seriously damaging the financial system and the economy.
Some observers have suggested that existing large firms should be split up into smaller, not-too big- to-fail entities in order to reduce risk. While this idea may be worth considering, policymakers should also consider that size may, in some cases, confer genuine economic benefits. For example, large firms may be better able to meet the needs of global customers. Moreover, size alone is not a sufficient indicator of systemic risk and, as history shows, smaller firms can also be involved in systemic crises. Two other important indicators of systemic risk, aside from size, are the degree to which a firm is interconnected with other financial firms and markets, and the degree to which a firm provides critical financial services. An alternative to limiting size in order to reduce risk would be to implement a more effective system of macroprudential regulation. One hallmark of such a system would be comprehensive and vigorous consolidated supervision of all systemically important financial firms. Under such a system, supervisors could, for example, prohibit firms from engaging in certain activities when those firms lack the managerial capacity and risk controls to engage in such activities safely. Congress has an important role to play in the creation of a more robust system of financial regulation, by establishing a process that would allow a failing, systemically important non-bank financial institution to be wound down in an orderly fashion, without jeopardizing financial stability. Such a resolution process would be the logical complement to the process already available to the FDIC for the resolution of banks.

So the only benefit of size he lists is "large firms may be better able to meet the needs of global customers." I can't say I find this argument very convincing.

In addition, I am not at all convinced that the procedures to "resolve a distressed, systemically important financial firm in a fashion that avoids disorderly liquidation" can be made credible. The first time regulators start to use this in a big crisis and markets begin to tank over worries about whether it will work or not, will the administration in power be willing to risk creating a big meltdown? Or will they resort to procedures used in the past that were problematic for all the reasons cited above, but do seem to prevent the most catastrophic outcome? 

Until someone convinces me that there are significant advantages to having mega-banks that cannot be duplicated with banks that are not, by themselves, too big to fail, I will continue to call for them to be broken up. Again, I don't think it makes a big difference in terms of systemic risk, though if Bernanke's right it will reduce the magnitude of the crisis, and that reduction in risk is important to recognize. But I do think breaking them up could make a big difference in terms of addressing all the other problems that size (and connectedness) brings about.

    Posted by on Thursday, September 2, 2010 at 12:00 PM in Economics, Financial System | Permalink  Comments (21)


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