Saturday, June 20, 2009

Firms are going to get themselves and financial systems in trouble, no matter what rules are adopted

From Free Exchange:

"Does size matter?
Posted by: | WASHINGTON

SOME critics of the adminstration's proposal for regulatory overhaul have focused on the fact that it seems to leave many too-big-to-fail institutions too big to fail. As bail-outs have grown in size and number through the past year, the mantra "Too big to fail is too big to exist," has become conventional wisdom among many regulatory reformers, but apparently the White House didn't get the message.

I am in agreement with Paul Krugman and Felix Salmon, however, in thinking it's not particularly important to focus on shrinking firms as a regulatory solution, for two reasons. One is that size is a poor proxy for the extent of the systemic threat posed by a bank. It's hardly ever the market capitalisation of a firm that makes it dangerous; it's how leveraged the firm has become, or how interconnected it is with other financial institutions. Targeting size will reduce some of the benefits from scale in banks while leaving smaller but dangerous firms free to go on destabilising financial systems.

It's also curious that upon determining that too-big-to-fail is a problem many observers conclude that firms need to be shrunk, rather than concluding that big firms need to be better at failing. If attempts to control the size of firms are likely to prove ineffective and excessively costly, then why not develop measures to improve the procedures for failure of systemically-important institutions? Specific resolution authority for complex financial institutions, such as has been proposed by the administration, is one step in the right direction. So too is a move to create central clearing facilities for derivatives. It might also be a good idea to charge banks systemic insurance premia in proportion to some measure of interconnectedness or leverage; then, the more likely an institution is to require a potentially costly resolution, the more it will have paid into a fund to finance that resolution (and the larger the incentive it will have to pare back destabilising activities).

Firms are going to get themselves and financial systems in trouble, no matter what rules are adopted; of that we can be sure. Best then to build a resilient and flexible regulatory regime that attempts to make players pay for the unavoidable presence of a government backstop. And that, it seems, is the direction the administration is heading, more or less."


Don the libertarian Democrat wrote:
June 20, 2009 20:18

The banks that viewed themselves as "Too Big To Fail" conducted business under that understanding. They took enormous risks because they assumed that they were implicitly guaranteed by the government. That doesn't mean that they expected the current crisis. Rather, they assumed that the government would intervene and effectively handle a crisis if it occurred. It seems clear to me, if not to others, that the size, power, and political clout, of these businesses, has not been good for the taxpayers. The straightforward point is that, if you leave them as is, they will be much more likely to influence regulators and politicians, and conduct riskier business, in the future. It's not at all clear to me that limiting their size wouldn't have benefits as regards risk.

If the government is going to guarantee a business, then it is well within its rights in asking that the business be run in a more conservative manner, that its size be limited, etc. In fact, to the extent that the taxpayers could be called upon to pay the bill, I see it as the duty of the government to put in place safeguards for the taxpayers.

The government's plan is a good plan, but one that, in my opinion, assumes that our system has just shown how resilient it is, not that, as I believe, we've just barely averted a Debt-Deflationary Spiral. Since that possibility was allowed under the current framework, I believe that we need more fundamental changes than have been outlined.

In a certain sense, there will always be "Too Big To Fail" businesses, and, should a crisis like this one occur, we can assume a massive government response. But that says nothing about how hard we should work to avert crises going forward. If you think, as I do, that we've just had Debt-Deflation, and just barely averted a Debt-Deflationary Spiral, it's hard for me to understand how this plan will significantly ease your worries for the future.

It's not that the plan is bad, it's that it seems to assume that what we're going through doesn't call for a thorough investigation of how our financial system is grounded. I just disagree.

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