Tuesday, May 5, 2009

The solution for banks is relatively simple: just put a cap on their size

From Reuters:

Felix Salmon

a good kind of contagious

May 5th, 2009

The risks of consolidation

Posted by: Felix Salmon
Tags: economics,

I had a short chat with Nassim Taleb this morning about his new paper with Charles Tapiero, entitled “Too Big to Fail, Hidden Risks, and the Fallacy of Large Institutions”.

There’s a great deal of mathematics in the paper, which is full of equations and greek letters, but the gist of it is explained in pretty plain English:

Societe Generale lost close to $7 Billions dollars, around $6 Billions of which came mostly from the liquidations costs of the (hidden) positions of Jerome Kerviel, a rogue trader, in amounts around $65 Billions (mostly in equity indices). The liquidation caused the collapse of world markets by close to 12%. The losses of $7 Billion did not arise from the risks but from the loss aversion and the fact that costs rise disproportionately to the size of the bank…

Consider the following two idealized situations.

Situation 1: there are 10 banks with a possible rogue trader hiding 6.5 billions, and probability p for such an event for every bank over one year. The liquidation costs for $6.5 billion are negligible. There are expected to be 10 p such events but with total costs of no major consequence.

Situation 2: One large bank 10 times the size, similar to the more efficient Société Génerale, with the same probability p, a larger hidden position of $65 billion. It is expected that there will be p such events, but with $6.5 losses per event. Total expected losses are p $6.5 per time unit – lumpier but deeper and with a worse expectation.

In other words, small mistakes we can live with. Large mistakes we can’t, because when a mistake the size of Kerviel’s is unwound, the costs are enormous — not only to SocGen, which lost upwards of $6 billion, but also to all shareholders globally, who saw the value of their holdings marked down by trillions of dollars thanks to the effects of SocGen’s enormous and chaotic forced unwind.

The lessons here are broader, and apply to the practice of M&A more generally: when industries consolidate, there might well be economies of scale — but at the same time tail risks increase. What happens when a massive amount of technology outsourcing is consolidated in Bangalore, or computer-chip manufacture is consolidated in Taiwan? Efficiency rises — but so does the risk that one disastrous event could have massive systemic consequences.

The solution for banks is relatively simple: just put a cap on their size. (I’ve been suggesting $300 billion.) What’s the solution for other industries, which also naturally tend to consolidate and cluster? I’m not sure, but in an increasingly interconnected and just-in-time world, the risks are greater than ever."


There’s a good post on this at The Economics Of Contempt:

http://economicsofcontempt.blogspot.com/ 2009/05/too-big-to-fail-experts-on-make- them.html

He mentions the following post:

“Addressing TBTF by Shrinking Financial Institutions: An Initial Assessment Gary H. Stern President Federal Reserve Bank of Minneapolis Ron Feldman Senior Vice President Supervision, Regulation and Credit Federal Reserve Bank of Minneapolis”

It’s a good and sensible post. Here’s one quote:

“On the first point, we anticipate that policymakers would face tremendous pressure to allow firms to grow large again after their initial breakup. The pressure might come because of the limited ability to resolve relatively large financial institution failures without selling their assets to other relatively large financial firms and thereby enlarging the latter. We would also anticipate firms’ stakeholders, who could gain from bailouts due to TBTF status, putting substantial pressure on government toward reconstitution. These stakeholders will likely point to the economic benefits of larger size, and those arguments have some heft. Current academic research finds potential scale benefits in all bank size groups, including the very largest.3 (Indeed, policymakers will have to consider the loss of scale benefits when they determine the net benefits of breaking up firms in the first place.)”

This makes sense to me, and even applies to the idea of taxing the size of banks, which I prefer. I prefer Narrow/Limiting Banking precisely because it’s harder to change politically. No doubt, there will be movements to change it. But we need a simple plan with simple rules. We’ve proven that we can’t handle complexity or lobbying or regulating very well.

An, yes, I bring this up just so that this plan will be considered. By the results so far, I’m not really the best person to advance this plan.

- Posted by Don the libertarian Democrat

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