Too Big to Fail = Too Big to Exist?

I asked this question on twitter/facebook and got a lot of variants of “I agree” and only one person who stated disagreement (but provided inadequate reason, IMO).  Jay Greenspan put it this way:

Interesting question this morning, and something I’ve been wondering about. I’ve yet to see anyone really argue that state of non-regulation we’ve been in for the last years has been a good idea.  I’ve heard some thoughtful conservatives talk about how their views have changed radically — coming to understand that forceful regulation is absolutely necessary.

The super-conservatives I’ve seen are talking more about taxes, avoiding the subject. I’d be very interested to see a credible argument for a hands-off approach.

So how about it, anyone game to take up a considered argument for not mandating that companies who get big enough to affect the global economy should be broken up or otherwise handicapped?

  • Ali

    Most commentators, IMHO, underestimate how many problems are in fact functions of government legal, policy and regulatory decisions. In other words, the systems we are seeking to regulate are not freely evolved organisms, but have evolved in response to or to take advantage of socially/governmentally established rules. As such, logic implies skepticism that additional layers of the same to would get us out of /prevent a recurrence of similarly large problems.

    Here’s a condensed example: If any one of us issued multiple titles to the same asset, we’d be in violation of certain laws which are simple codifications common sense. Depository institutions (your bank), however, operates under a loophole: put $100 in your checking account and the bank tells you it’s available at any time even though it lends out $90. This is nonsense, not common sense.

    Yes, yes, I know, “What are the chances that everybody will want their money at once” blah blah. The answer, historically, is quite often, but that’s another story. It’s extremely difficult to build a sound system based on a series of fundamentally unsound transactions. The New Deal answer was Federal insurance of deposits. It should tell you something about a business model that has needed 70 years of Federal insurance (e.g. FDIC) for its fundamental activity and key source of financing (taking customer deposits). In return for this insurance, banks have been heavily regulated generally with an eye toward reducing the risk of how the money is lent out. An financial and political problem, however, can build up to the disasters at hand. First, when the cost of capital (customer deposits) isn’t a function of the investment risk because of the Federal insurance, there is an incentive to seek maximum investment risk since your financial spread always increases. So the regulators are always fighting an uphill battle to control bank activities. Second, it’s politically attractive to enable home ownership so there’s always pressure to let banks lend, or worse further enable them through less direct subsidies of their cost of capital (ie Fannie Mae and Freddie Mac, which borrowed at government rates).

    Now, take the original loophole and insurance away you will be left with vehicles with much more intuitive set-ups: PE funds, VC funds, hedge funds, mutual funds where you understand that your investment is illiquid, semi-liquid and/or subject to capital loss, or money market-like funds which seek very strong capital preservation and liquidity by investing in very short term, very liquid, typically debt securities. The lightly regulated money market industry has a better history of capital preservation than the regulated banking industry when you back out FDIC payouts.

  • Ali, great points.

    I’m curious though, do you think that similar situations where an organization individually gets too big to fail can arise in a “freely evolved” fashion? In other words, we can always stop a specific scenario like the current one from happening again, but the larger issue remains. And thus, should there be a provision to balance the ecosystem once it gets unbalanced?

    My contention is that all freely evolving systems straddle the edge of chaos in a more or less precarious fashion, and adding the appropriate feedback mechanisms can serve to stabilize.

  • Ali

    Not sure I understand the point, but two questions and a comment:

    Is there such a thing as a too big to fail entity, and if so how many are there? I’m not convinced (but could be convinced) that GM, AIG or Citi or others were too big to fail.

    Second, how do we identify such an organism and do we know enough to establish the appropriate feedback loop. In other words, some “problems” and “risks” are a feature of an evolving complex system. If we could remedy, the complexity is probably too small for the system to be vibrant. The way we’ve authorized and regulated banks is reflects the downside of hubris.

    For this and my prior stated reasons, I’m not sure I agree that we can prevent specific scenarios from recurring. This financial crisis is at least the third major one in the US in the last 125 years. The current remedies are transferring failure risk from institutions to the Federal government, as the penalty for “non-organic” constructs (legally sanctioned issuance of multiple titles on the same financial assets) cannot be regulated away while maintaining the faulty construct underneath.

  • Ali, again great points/questions. Regarding preventing specific scenarios from recurring, I was referring to the idea that we do in fact do this all the time, but it’s the wrong thing to do. That is fixing the last problem (e.g. the airport security farce) just means that the black swan comes from somewhere else.

    As for identifying such organisms, I agree we can’t do so. But we might be able to prevent them from emerging with the right stability mechanisms. See here, here and here for thoughts on the subject.