"Does size matter?
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- Economist.com | 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."Me:
Don the libertarian Democrat wrote: