Wednesday, April 14, 2010

Too Big To Fail? I'd Be a Fool Not To Invest!

The question of what caused the housing and banking crisis we are now in* is more than just an academic question - the root causes have profound implications on what we might change to avoid doing this all over again in 2020. There are a number of schools of thought on what made bankers do what they do: were the banks the dumb money, did they knowingly dig a hole, or were they pushed in the direction they were pushed by the structure of the system?

Jeffrey Friedman refutes the notion that bankers acted irresponsibly because they knew they were too big to fail. This is probably true. (I would argue that they acted irresponsibly because they'd make huge amounts of money in the very short term for doing so.) But the entire issue is a bit of a red herring; the problem with Too Big To Fail isn't that it makes bankers do stupid things; the problem is that it makes investors do stupid things, and it forces us to pick up the bill.

There are two fundamental problems with really, really big banks:
  1. They are so big that we don't have a practical way to disassemble them if they go bust. The FDIC does a great job of taking apart small banks. But this process won't scale up to an institution as large as Citi or BoA. See Simon Johnson's comments.

    So the first problem with TBTF is that should a TBTF bank go bust for any reason, we're going to end up picking up the bill with a giant bail-out. It doesn't matter whether the banks sink the bank intentionally; unless you believe that bankers are infalliable and will never screw up, you have to recognize that TBTF is hazardous to the well-being of the American taxpayer.

  2. Even if the bankers aren't counting on a bail-out, the bond-holders may be. If there is a lesson to be learned from this crisis, perhaps it is this: BoA and Citi's debt is safer than that of smaller institutions because BoA and Citi can't be put into bankruptcy or liquidation due to their enormous size. Therefore if they do fail, a bail-out is a more likely solution than liquidation.

    The problem with this is that this is going to make their debt less risky to bond-holders; private investment will be directed toward these large institutions because of their "structural guarantees" (that is, they are so huge that their disposal in the event of disaster is going to be in the form of a bail-out, not a liquidation). Thus they will have cheaper funding (since their debt is less risky) than smaller banks, and thus they will be more profitable, crowding out otherwise more fit competition. (And you thought there was no economy of scale in banking?)

In summary, my problem with TBTF is not that it caused the crash; my problem with TBTF is that it caused me to get stuck with the bill, and it's going to make the next crash more likely.

The Democrats talk about regulation, and the Republicans talk about ending bail-outs, but I am waiting for either of them to do what would really make a difference (but go directly against a huge stream of lobbying dollars): break up the biggest banks into smaller pieces. Too Big To Fail is just Too Big.

* Some insist that it is strictly a banking crisis - those of us who have lost significant value on the houses we own, or are in some other way connected to reality, think otherwise.

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