The Good And Bad Of Banks Too Big To Fail Getting Bigger...

from the not-all-bad,-but... dept

Ever since the whole financial crisis began, and the concept of "too big to fail" became a common phrase, I've been wondering why the US gov't didn't set up a simple provision in any bailout procedure: if you are too big to fail, and because of that need a gov't bailout, then a part of that bailout means you need to become small enough to fail. I think it's a perfectly reasonable suggestion that has been pretty much totally ignored.

So, when news came out that the biggest banks, the ones deemed "too big to fail," are now getting even bigger, you might think that I'd view that as a bad sign. And... partly, I do. But not for the reasons you might expect. The issue of "too big to fail" isn't the bottom line size of the bank, it was about how interconnected it was in the rest of the economy, and how any ripple effects of a failure would damage (significantly) other parts of the economy. But, since the government has done pretty much next to nothing to actually deal with that sort of systematic risk (and, no, putting in place a "systematic risk" manager, as we keep hearing, isn't going to fix the problem), it should come as no surprise that these banks still have such risks.

But, the fact that, by themselves, these banks are growing isn't a bad sign. Given what the government has done, it's actually a good sign. You should be a lot more upset if, after the government gave these banks so much money, they went out and lost it all. Instead, many of them have at least put it to good use (and some have returned money to the government at decent interest rates -- though, the amount returned still is a blip compared to the amount at risk).

The real issue isn't the size of the banks, but how interconnected they are. But little to nothing has been done to take on that problem -- which is a bad thing. However, given that, it's at least a decent sign that these banks we've given so much money to are actually doing better these days.

Filed Under: banks, radical transparency, risk, systematic risk, too big to fail, transparency

Too Big To Fail Isn't The Problem... It's The Hidden Risk That's The Problem

from the as-if-that's-possible dept

Duncan Watts has a thought provoking writeup in the Boston Globe talking about the problems of systematic risk, and why no one could successfully see exactly how the various dominoes would fall, leading to our current (and still ongoing) economic financial crisis. Basically, his argument is that the system has become too intertwined and complex, such that no one can really manage the risk. This is hardly a new idea. Watts' suggestion (which, again, is not necessarily new, and has been discussed by many, including Treasury Secretary Tim Geithner) is that perhaps we need a "systematic risk manager" within the government, whose job (like anti-trust folks) is to look at various companies and determine if they're too big to fail -- and then see how to change things such that they're no longer too big to fail.

It's a nice idea... in theory. In practice, it's a lot harder. The very reason systematic risk is such a problem is that it's so hard to even imagine the scenarios taking place. The idea that Lehman Bros. failing would have so much impact elsewhere is simply beyond the scope of what most people could have even imagined -- and that would almost certainly include any "systematic risk manager." While I agree that it's a problem that we end up with companies that are "too big to fail," I tend to think, in the long run, it's futile to try to predict ahead of time who's really "too big to fail," but that such an issue should only come up in the event of a gov't bailout. Thus, if you need to take gov't money to stay alive because you are deemed "too big to fail," then it should be required that as a part of the terms of the deal, you need to work out a plan that makes you small enough to fail.

Otherwise, you end up in a situation where companies who are successful get penalized for it. The only time "too big to fail" is a problem is when such a company fails. We shouldn't necessarily be penalizing a company that's too big to fail if it's not going to fail.

Separately, Watts notes that this idea of trying to prevent "too big to fail" is a way of avoiding systematic risk. I'd argue he has the equation a bit twisted. Too big to fail isn't the problem. It's the hidden risk that leads a company that is "too big to fail" to fail that's the problem. The answer to that is not breaking up successful companies -- it's increasing transparency into actual risk. That means increasing openness and data sharing, rather than the status quo of quarterly reports with the real details hidden and buried beneath complexities, combined with Wall Street putting together packages whose sole purpose is designed to hide the actual risk. Make the real data transparent (and real-time) and let anyone access and mess around with the data, and you get a much more accurate view of the risk, and you avoid situations where "healthy" investments suddenly turn sour.

Watts has the right idea that systematic risk is a problem, but the wrong solution. Companies that are too big to fail failing is a symptom of a lack of transparency over the actual risk. The answer isn't to stop companies from getting so big. It's to provide more transparency into the actual risk.

Filed Under: radical transparency, risk, systematic risk, too big to fail, transparency