Are Big Banks 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 homebuyers is simply absurd. These mammoth nodes – especially Fannie Mae (FNM) and Freddie Mac (FRE) - 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 U.S., which 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 U.S. 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 (MER), Morgan Stanley (MS) or Lehman Brothers (LEHMQ.PK), 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 (BAC) and Citicorp (C) 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). However, what we got was 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. However, 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.

Comments

[appone:]

Simple, and to the point. Unfortunately, the government likes big institutions and the trend appears to favor the same.

2008 Oct 20 08:20 AM

[moonbat1775:]

Some people seem so wedded to fractional reserve banking that they cannot conceive of an alternative. An alternative that is honest, flexible, and stable is competing currencies with 100% reserves. The reserves could be any commodity, good, or service. The market place would quickly pick a few favorite currencies and reserves. All the government would have to do is enforce the usual laws against fraud and insolvency.

If we do not adopt economic liberty with respect to money, then our choices are a heavily regulated stagnant banking system or a lightly regulated unstable banking system or some so-called "happy medium".

2008 Oct 20 08:30 AM

[css1971:]

Regulated? Oh come on, you must be kidding.

The Federal Reserve is a cartel set up to protect and serve the biggies in *exactly* this kind of situation. And it is working like a bloody charm.

Here's the thing. If you are "too big to fail" then you are literally, a threat to national security. If you are a threat to national security then you should be run as a government department. The banks which are too big to fail should become fully owned parts of the treasury. Otherwise you just have a government supported and mandated oligopoly.

2008 Oct 20 09:29 AM

[Reinko:]

The FDIC cannot be 'brought down' because a bank is 'too big'.

The FDIC 'insurance fund' has no real money in it; it is only an accountancy vehicle that measures how much 'insurance premiums' the banks have paid and how much is withdrawn from that 'fund'.

In the fund are only Treasuries, even the coupon is paid with more Treasuries. The money the banks paid over the last decades is long gone and spend on everything from military stuff to whatever what.

Each and every bank failure is paid by enlarging the US Federal deficit.

Don't forget: If you add up all those fake funds in the US government (it is so called hidden debt that brings down the official deficit) and add the official deficit you are over 100% of the US gross domestic product...

2008 Oct 20 11:52 AM

[Smarty_Pants:]

moonbat, we can start our own bank with currency backed by paper and ink. No fractional reserves. For every bill we issue, we'll have paper and ink behind it.

Our slogan: "Banking. It's just numbers on paper."

Nothing like truth in advertising, eh?

2008 Oct 20 12:43 PM

[moonbat1775:]

Smarty,
You raise a good point. What meaning does "fractional reserves" have when the "reserves" are paper?

2008 Oct 20 12:50 PM

[moonbat1775:]

Smarty,

Another point. Apparently, the currency is getting so debased that even paper is too expensive. Will the new larger denominations (ala Zimbabwe) have Greenspan's and Bernanke's pictures on them?

2008 Oct 20 12:55 PM

[Smarty_Pants:]

moonbat,

No portraits or we will cause inflated egos. I was thinking pictures of various types of helicopters for the denominations.

No need to worry about paper costs. Instead of issuing new denominations we will simply have our customers write in the new zeros. We can plan ahead and leave room on the bill for such additions.

We won't even have to pay for the ink this way. Bonus profits!

2008 Oct 20 01:00 PM

[moonbat1775:]

"What a twisted web we weave, when first we fractionate to deceive."

2008 Oct 20 01:10 PM

[Smarty_Pants:]

(With apologies to Pink Floyd)

Banking!, get away.
Got a good job with stock options and I’m doing okay.
Banking!, its a gas.
Leverage that cash with both hands and lend it fast.
New car, caviar, FED star daydream,
Think I’ll buy me an insurance team.

Banking!, best thing yet.
I’m all right jack don’t you audit my toxic debt.
Banking!, it’s a hit.
Stated income isn’t just goody-good bullsh_t.
I’m in the high-finance lending section
And I haven’t even started CDOs yet.

Banking!, so they say
Is the root of all evil today.
Banking!, it’s a crime.
I’ll never worry about doing any time.
But if you miss a payment it’s no surprise that they’re
Locking you away.

2008 Oct 20 02:18 PM

[moonbat1775:]

suicide by banker

The bloody, bloody bankers,
a most respectable lot.
How many millions have they starved?
How many have they shot?

The bloody, bloody bankers,
since 1694,
booms, busts, depressions
and never ending war.


Apologies to those who have to clean my blood off the walls, etc., etc.

2008 Oct 20 02:30 PM

[madasiwannabe:]

Fannie and Freddie were well regulated... The regulators were right there to ensure they had enough liquidity to take on mortgages as the bubble grew. When they ran low, the regulators reduced their capital requirements. When the banks were taking on too much risk with Sub-primes, the regulators had the GSE's drop their bar and take some of that paper off their books. When things went south, they were right there to place the blame. Now the same regulators that are legally responsible to protect the companies assets and return them to profitibility want to use them as toxic waste dumps to clean up the balance sheets of greedy banks.

We need more of these guys around to make sure things go hopelessly wrong next time.

2008 Oct 20 08:01 PM

[ashizashiz:]

Beware

A Jedi's strength flows from the Force. But beware the Dark Side. Anger, fear, and aggression; the Dark Side of the Force are they. Easily they flow, quick to join you in a fight.

Mr Bernanke said today: “With the economy likely to be weak for several quarters and with some risk of a protracted slowdown, consideration of a fiscal package by Congress at this juncture seems appropriate.” He added: "If the Congress proceeds with a fiscal package, it should consider including measures to help improve access to credit by consumers, home buyers, businesses and other borrowers. Such actions might be particularly effective at promoting economic growth and job creation...”

"Access to Credit!!!" Unba-fucking-real. These guys have absolutely no shame, not a moral or ethical cell in their malignant souls.


Give the stupid, ignorant mass of poor slobs money so that they'll feel OK about getting into MORE debt; give 'em that false sense of wealth---like the one "W" gave 'em with the $600 'stimulus' checks---so that they feel OK about getting 3 new credit cards and running up $7500 in debt and paying the minimum payment each month of $50 while NEVER, EVER getting close to getting out of debt. Debt servitude, for all of your days. Pay the man and make him rich.

Look folks, this has gotta stop. We cannot exist forever as the meat for the financial industries sausage grinder. There are many ways to get out from under this pile of shit, but one very straightforward method comes to mind first: stop playing.

Stop borrowing money from corrupt banks and stop paying money to a corrupt government. Don't pay your taxes, don't take out new mortgages, don't patronize the institutions that prop up this system. Live smaller---live in and for your community. Grow vegetables, trade with neighbors, share resources. Don't buy cool things anymore---you don't need them. One small TV is just fine...in fact, my wife and kids and I have chosen not to have TV in our home. We listen to the radio and occasionally watch M*A*S*H on an old DVD player. Don't buy into the need to buy into happiness. Ride a bike to work.

The Empire cannot make us go to THE DARK SIDE. We have a choice. The Dark Side exists on greed and excess and hubris. If we can learn how to live small, the forces of Evil will fall. They can only exist if we subsidize their existence. I say, no more!
Here is a great video about THIS VERY TOPIC:

video.google.com/video...

2008 Oct 21 10:07 AM

[djsunshine:]

Why blame banking!!!
Housing became unaffordable long time ago..30% DTI is not possible specialy on east and west cost. No income verification was a natural answer by wall street to gain and keep market share. The problem was HIgh leverage, risk pricing and default swaps..when it becomes a 'econpmics of large numbers' behaves diffrently..the whold model was not functioning..Now we have a choice..go japan way making home mortgage rate 1% payable in two genration or let home prices go down at depression level at least on east and west coast. I think option ARM was an answer to that problem( or 30 yr baloon). But feds raised 12 MAT so much and margins on them are so large it killed everyone.
NOw rates are down but margin is killing everyone. House prices has not gone up and payments have adjusted too high.
Feds must cut down the margin and put everyone on a baloon and or lowrate fixed rate.

2008 Oct 21 11:00 AM

[monday1929:]

ASHIZASHIZ is correct- Stop feeding the consumer monster. Reduce consumption and starve the beast. Companies want to downsize me? I will downsize THEM.

2008 Oct 22 07:53 AM