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October 20, 2008

Too Big to Fail

There's an excellent article in this morning's New York Times which begins:

"The financial crisis is forcing regulators to encourage the creation of bigger, more interconnected institutions. In the short term, this may serve a useful purpose by allowing healthier, well-capitalized banks like Wells Fargo, Bank of America and JPMorgan Chase to shore up weaker ones.

"But it also presents a serious threat to the financial system by fostering financial behemoths that are, to use Federal Reserve Chairman Ben S. Bernanke's euphemism, 'systemically critical.' Policy makers need to start thinking about how to downsize institutions that are becoming 'too big to fail' before the situation comes to that."

"Systemically critical" is a good phrase even though it sounds like jargon. Those of us who have built complex interactive systems know that nodes which are significantly large compared to the network as a whole pose an outsized risk. The Internet is a triumph of decentralized relatively small nodes, none of which is "too big to fail". There are always nodes failing on the Internet; this is the normal state. A brilliantly simple architecture allows the network as a whole to remain functioning despite constant failure of nodes. Because the nodes themselves don't have to be made failure-proof (which is impossible anyway), the nodes are so cheap that redundant nodes are easily affordable.

The current crisis began with the failure of mammoth nodes – blaming it on improvident home-buyers is simply absurd. These mammoth nodes – especially Fannie Mae and Freddie Mac - accumulated risk in a way that would have been impossible in a more decentralized time. Some community banks would certainly have been imprudent even if they'd had to keep the mortgages they wrote on their own books (remember the S&L crisis); but the system could much more easily have tolerated the failure of a few of these small nodes AND their failure would have encouraged others to be more prudent.

Until the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 branch banking across state lines was forbidden in the US; that was a significant barrier to horizontal concentration. Bank holding companies were not allowed to own non-financial institutions until the passage of the Gramm-Leach-Bliley Act in 1999, a barrier to vertical concentration. Both acts were passed not only because of huge lobbying efforts by financial institutions which wanted to grow but also because there was a perceived (and quite possibly real) need to allow US banks to grow large enough to compete with less-constrained foreign entities.

With the limits gone, the monster banks grew albeit with some regulation, especially around their FDIC-insured deposits. However, this regulation did not include institutions like Merrill Lynch, Morgan Stanley or Lehman Brothers which were non-bank holding companies and could neither own banks nor offer FDIC insurance to "depositors". These institutions had the advantage of light regulation but the disadvantage that competitors like Bank of America and Citicorp could offer a full range of bank and non-bank services and had a base of insured deposits which wouldn't flee in a crisis. In recent months all of these either failed (Lehman), merged into bank holding companies (Merrill), or converted and became "banks" subject to regulation (Morgan Stanley). But we got even more concentration.

There's no question anymore that institutions which are too big to fail are also too big to leave unregulated. There is significant question whether any degree of regulation will be sufficient to prevent failure. Nodes fail for unexpected reasons – usually not the ones you're watching for. Fannie Mae and Freddie Mac were regulated; that didn't help much. The problem of adequate regulation grows even worse when government owns a stake in what it regulates and, of course, that's exactly what's happening with the banks.

Perhaps, immediately after the immediate crisis we need a form of antitrust which limits the size of financial institutions. Part of this might be accomplished by reducing the amount of federal deposit insurance on each account (this was just raised) to force investors in search of the safety of such insurance to spread their wealth among banks. Maybe the total amount of insured deposits any institution can offer should be limited; this step would eliminate the risk of having institutions big enough to bring down the FDIC itself. In a global economy, such limits will be very hard without similar steps being taken worldwide. But it's a better problem for world financial leaders to work on than weekly rounds of "coordinated" bailouts.

Nothing should be too big to fail because nothing can be made failure-safe.

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