Thursday, November 26, 2009

More on "Too Big To Fail"

I've posted before about "Too big to fail," and it's back in the news again with discussions about regulatory reform. Planet Money (which I love) has been talking a bit about it, as has the Motley Fool.

As I've thought about this issue more, I've realized that the issue is not that we need to regulate entities when they become "too big" per se. Rather, the problem is that being "too big to fail" is actually saying something more subtle: the entity has introduced systemic risk into the system.

Boeing is a huge company, and were it to implode tomorrow it would cast a lot of damage in its industry and among its suppliers and would be an all-around "bad thing", but it would not destabilize the economy as a whole or unrelated industries. Lehman's implosion, on the other hand, demonstrated that it's risk-taking ultimately inflicted severe collateral damage throughout the entire financial sector - and ultimately throughout the entire economy as lending froze up in its wake.

So the issue is not size, and asking if we should break up banks if they become too "big" (which begs the question of how big that is and how you know), but rather that regulators should have full authority to be alert for introduction of systemic risk, and should be empowered to strictly regulate such behavior above and beyond whatever regular day-to-day regulation they are authorized. Maybe it means breaking up large companies, but when viewed in this light, breaking up a company becomes just one possible tool at a regulator's disposal, not the default.

By the way, I also particularly liked this quote from the Motley Fool article, which I think cuts through the heart of any anti-regulatory ideology on this point:

A commenter to our article suggested that suppressing the scope of banks runs contrary to the free market. "I guess you don't believe in free enterprise, and ... neither does the federal government," the poster wrote. This couldn't be further from the truth.

Economic freedom relies on individual risk-taking. In our current financial system, the stupidity of a few reckless bankers and traders creates unintended collective risk-taking. It's as far from freedom as you can get. We want a system where bank failures wreak havoc on stakeholders of just that bank, and nothing else. You can still screw up; just leave me out of it. That's freedom, and we're big fans of it.

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