What is Too Big to Fail?

There seems to be various discussions going around about who needs to be considered Systemically important to qualify for “Special Attention” from regulators. Very large money managers are saying that they are not systemically important.

But it seems to me that there are quite a number of considerations. And everyone seems to be arguing solely from the part of that list that exempts them.

When thinking about money managers, I would think of the following:

  1. How is their liquidity managed? Can they really raise funds fast enough to satisfy a run on the bank?
  2. If they were to try to liquidate their funds, what would that do to the financial markets?
  3. How interconnected are they to other financial firms? Do regulators now have information about that?
  4. What about the future? (Isn’t that our concern, not the past or even the current situation?)
  • Could they shift their liquidity practices to become much more illiquid?
  • Their argument revolves around leverage, how much could they change their leverage under their current regulations? They can quickly leverage through derivatives as well as borrowing.
  • Could they become the center of new risky financial behavior that would endanger the financial sector?

That last point is a major concern of regulators regarding the Insurance industry. And they have history on their side. The insurance industry helped the financial sector to blow the mortgage business up to 4 or 5 times the underlying.

All you need to do that is a big balance sheet and a willingness to take one side of a trade without balancing it with the other side. And the money managers as well as the insurance companies both have exactly those characteristics.

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3 Comments on “What is Too Big to Fail?”

  1. Robert Arvanitis Says:

    We have broken up monopolies since Teddy Roosevelt and the Sherman Act. Now we need to bust “Too big to fail” as well.
    Ok.
    Whatever is needed to preserve the premises of free markets – many small independent agents, free flow of information, no collusion, no tariffs, no monopolies and no TBTF.
    That way, we will enjoy the full benefits of the “wisdom of crowds.”

  2. Robert Arvanitis Says:

    “Too-big-to-fail” firms are the spawn of wrongheaded regulation.

    If regulators were not bail-out patsies, then the fear and greed would balance naturally among all counterparties. Failures would be frequent, and small, thus providing continuing lessons in prudence.

    A VISUAL: Imagine lemmings along a sea-cliff. If one got too close and fell off to his doom, the others would shy back from the edge. Instead, regulators see the crowd and rush to shore up the cliff (just like the preposterous homes of Malibu). That allows more lemmings to crowd even closer to the edge, requiring yet more regulatory intrusion. Stop fighting Darwin.

    A DEMURRAL: Blaming insurers for the crisis is like blaming a mugging victim for carrying a wallet. Yes the victim was stupid but no, the victim did not turn an honest person into a criminal.

    • riskviews Says:

      There are several fundamental difference between biological organisms and businesses.

      One is longevity. Businesses can potentially live a very long time. While biological organisms tend to have fairly short life spans.

      The second is that biological organisms usually have fairly small individual limits. A lemming can only grow to be so large. But businesses can grow as large as they are allowed. The longevity point feeds this as well.

      So if we want to pretend that Darwinism applies to businesses, then we ought to change the nature of businesses so that they are not potentially immortal and so that they all stay within a similar size.

      Otherwise, we should be more realistic and look for theories that apply to the actual nature of the phenomena that we are addressing.

      In a capitalist system, the primary objective of most businesses is to create a sustainable competitive advantage. That is the modern jargon, right?

      The older term for that is a monopoly.

      So businesses all seek to become the sole source of the good or service that they provide.

      Since we have chosen not to limit businesses in that regard, then society is at risk from the potential failure of any firm that has become a large enough supplier of any vital good or service that their failure would endanger society because the other firms (if any) that provide the same vital good or service cannot quickly replace that provider.

      Think of this example, if you allow the provider of fuel for heating in Alaska to become a monopoly, then then you cannot let Darwin take care of that firm if they suddenly fail, unless you want lots of frozen Alaskans.

      Or maybe you ARE saying that because we have been so stupid as to allow a few firms to dominate our financial system, then it is an appropriate Darwinian solution for us to simply fail as a society the next time those few firms go off the ranch?

      But in fact, I do agree with you that failures of smaller firms (firms the size of single lemmings compared to the entire lemming population) is a good way to operate our system. But for our system to operate in that manner, we would have to break up the largest firms into much smaller firms.


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