TimT

Government's Next Lesson: Small Is Beautiful

I wrote the following thoughts on Sept 18th...obviously much has changed since I wrote it as we see what the Gov't has done since then. However, the premise holds.

Too Big, Too Risky

Decentralize and Recapitalize our Financial System

The world changes when we choose to change the way we think about it.

We can see now more than ever that financial entities are interconnected to form a functioning whole much like computers form an interconnected neural network to form the internet. The IT industry knows full well the strategic advantages of distributed data processing as opposed to centralized processing. If you look at a conceptual map of the internet you’ll see tens of thousands of interconnected computers, some more powerful than others able to handle more processing and more data traffic, but all interconnected. The strategic advantage of a distributed system is that if any single node or computer goes down other pathways are found and used to process and move data, thereby enabling the whole (internet) to function with little or no friction, certainly without crisis. Even if a large node of the internet goes down, other computers take up the demand for data processing and data movement. The main point is that no single node is so large that its’ demise or malfunction brings down the whole internet. Knowing now how interconnected our financial system is, wouldn’t it be safer and work better if no single financial entity could significantly impair or bring down the entire system?

This discussion evokes the now familiar topic of the “too big to fail” doctrine. My point is: Why so big in the first place? While I haven’t researched the facts, at this point my gut tells me that gigantic corporate size in financial institutions has primarily benefited Management and not Shareholders. I’d like to see what the numbers show, especially after this 100 year financial storm we’ve now had. I think responsible investors should take a hard look at disproportionately large financial institutions and demand a premium for the systemic risk they pose. The problem is that when the investor knows the Government stands waiting to backstop a failure, then the opposite occurs—investors pay more for this implied reduction in risk—this “free lunch,” if you will. This is a huge problem. How do you or should you limit growth-in-size of a financial institution in a free market economy? I don’t claim to have answers to this complex issue but I wonder if a good start would be for regulators to impose higher capital requirements when financial institutions get beyond a certain size and even more so if they decide to get bigger and their risk to taxpayers becomes larger. Bill Gross and other respected financial professionals have said it, the system needs capital. I can’t agree more. The problem is where’s it going to come from now that the cows are already out of the gate and deleveraging is underway? I don’t know the answer to that either but capital must come into these large institutions. Having adequate capital would allow the free market economy to do its work without the need for government bailouts and taxpayer liability, clearly an embarrassment for Free Market Capitalism.

We (banks and financial institutions) are headed for sweeping regulatory changes in the next two years because of this mess. Let’s hope our politicians see the big picture of what would create real strength in our financial system, rather than continuing down the path of supporting essentially a centralized financial system consisting of just a handful of gigantic financial institutions that make an unstable whole. And let’s hope they are wise enough to see the value of equity capital in a free market economy and just let it work. Over-regulation is not the answer at this point.