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Are big banks too big to fail or are they too big to regulate?

Nov. 29, 2010 6:32 PM ETC, BAC, WFC, JPM
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Are big banks too big too big to fail or are they too big to regulate? This is a real question that faces the regulators in each country. Ultimately, banking is a a regulated industry in a sense that politicians are responsible for making sure that it performs adequately its core functions of savings, lending, payments and capital raising. Yet the game has changed significantly over the last two to three decades. And the events leading up to the financial crisis only accelerated this change. This was driven by growing complexity of modern finance, a global nature of business activities of big banks and the OTC form of derivatives markets. At the end, country regulators became unable to rein in the activities of truly global players. After the crisis, each country decided to impose new "tougher" regulations on banks and make them "pay", at least in the eyes of the public, for expensive and well-publicized bailouts. Yet, the critical loophole has not been closed yet. Banks can and do play a game of a regulatory arbitrage. Multi-layers ownership structures, off-balance sheet balances liabilities, and multi-country jurisdictions made it impossible to effectively manage large banks in the current framework, where responsibility rests with each country regulators. Each big bank is too big to manage for each country regulator. Therefore, such a bank becomes automatically too big to fail since risks for each country's financial systems are too complex to understand and regulators are too scary to deal with them. The default response then is a bailout. But globally banks can be regulated effectively, risks they carry can be understood clearly and their orderly unwinding can be executed without a Lehman-type of damage to the economies.
So, is the global regulations of big banks a way to go then? Well, like the famous game theory puzzle called prisoner's dilemma states, people can end up with sub-optimal outcomes even if a better one is clearly visible to everybody involved. What is more important for each country: to make an attempt to create a global regulatory regime or to increase individual country competitiveness, by making it "easier" for banks to do business in it? As the Irish bailout shows, the banks and their senior bondholders are still the kings. Their are to be kept whole at all costs.


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