Too Big to Fail

Too Big to Fail

1^st November 2009

The Malta Independent on Sunday

Alfred Mifsud

Now that the international financial crisis appears to have stabilised after massive interventions by governments, monetary authorities and regulators, focus is shifting from mere survival to re-designing the financial system to ensure that what happened will never happen again.

In this context the whole argument revolves on how to tackle the “too big to fail” moral hazard risk.

If failure of one of the smaller financial institutions like Lehman Brothers proved big enough for the whole financial system to seize up, then the new regulatory regime has to be designed to ensure that no single institution, no matter how big, should pose such a grave systemic risk.

The present system of moral hazard is untenable. It is scandalous that significantly important financial institutions are allowed to pass on to their shareholders and their bonus rich employees the benefit of the profitable years in the knowledge that if they hit a rock the taxpayers will bail them out, as they are too important to be allowed to fail without bringing down the whole financial system.

There is therefore broad agreement that in the new regulatory regime no financial institution will be allowed to be, or become, too big to fail. After all, failure lies at the core of market based systems and we cannot safely have a properly functioning privately owned market based financial system if the possibility of failure is excluded and the taxpayer can be relied on to underwrite losses to save the system from imploding, as happened in 2008/2009

Where there exists a substantial difference of opinion is over how the “too big to fail” institutions can be forced to downsize and thus stop being a systemic risk if allowed to fail.

There is one school of thought, championed by the governor of the Bank of England Mervyn King, which argues that the problem has to be addressed in a direct manner. Institutions categorised as being systemically important simply have to be forced to get smaller by separating their traditional deposit taking and financial intermediation role from their investment banking operations.

This would largely be a return to the Glass Steagall Act of 1933 introduced in the US following the Great Depression, which effectively prohibited commercial banking (deposit taking and commercial lending that was considered as a utility provision critically important for economic growth through the supply of credit and therefore prohibited from undertaking risky speculative dealing in market instruments for their own treasuries) from teaming up with investment banking, which effectively gets involved not only in executing third party deals but operate their own large treasuries taking risky positions in trades for their own account. Mervyn King has reiterated that casino operations have no place to co-exist within banking organisations providing credit utility services.

Another school of thought considers such an approach impractical, as it is unlikely to find international application and would merely involve regulatory arbitrage with large banking organisations merely shifting to a softer regulatory regime. In such a case, London, which is where Mervyn King has his throne, being the largest international financial centre, would be a net loser. This explains why King is not exactly the darling of the British Chancellor of the Exchequer Alistair Darling.

The school of Alistair Darling argues that it would be difficult and indeed unreasonable to force such a direct division. To be effective, such a division would have to mandate that investment banks be wholly financed outside the commercial banking system so as not to retain any indirect exposure by the latter to the former, and this is quite impossible. Furthermore, it is quite imaginable that if such strict separation were enforced, commercial banking per se would gradually wither away as depositors would switch their deposit funding on low rates to higher income funding on the markets offered by the investment banks. This would effectively downgrade the critical financial intermediation role of the commercial banking system.

The Darling school of thought wants to address the “too big to fail” anomaly by introducing more rigorous capital requirements for banks, which apart from conducting pure commercial banking operations also operate investment banking operations, as all large international banks currently do. So their argument goes that the bigger the bank, and the bigger the risks undertaken by such big banks, the bigger the capital requirements demanded. Effectively, this would act as a market-based disincentive to keep large investment banking operations within the same structure of commercial banking. In time, banks would realise that it would be more profitable to conduct such investment banking operations in hedge fund types of structures, which are entirely funded by investors capital, with strict limits on leverage, and which can pay as much bonuses as they want to their star performers, as their operation would not involve the taxpayer in any expense or subsidy, or even in implicit guarantees.

Building on this concept, the US House of Representatives banking committee is proposing that any future bail out funded by taxpayers would have to be funded directly by taxing the surviving banks. There is an argument whether such funding should come a priori by building reserves in good times, as is done with the operation of the deposit insurance schemes, or should be triggered by events a posteriori. Many argue that the latter would be quite difficult, as the triggering event would render surviving banking institutions too weak to carry the burden of additional taxation.

This financial crisis has produced new catchwords and phrases that will remain embedded in the language. We have now passed from “toxic assets” to “too big to fail”.

It is inevitable that the banking sector has to pay the price of much heavier regulation once it has proved itself untrustworthy to operate in a light touch regulatory environment that relies on self-regulation. Banks have involved the taxpayer in heavy losses and shamed their regulators and monetary authorities who had defended their freedom as leading to better risk distribution and financial efficiency. Events have proved that the reality was totally different.

Banks that survived are not helping their own case by resorting so quickly to scandalous employee bonuses distribution without taking into consideration that their own survival is due to explicit or implicit taxpayer guarantees, and that the huge profits they are registering after the huge losses of the crisis are only due to the exceptionally low interest environment that monetary authorities had to engineer to facilitate the recovery. Such short-term reasoning by greedy bankers will only mean more and stricter regulation for the longer term.

How to resolve the “too big to fail” hazard remains under discussion. But it has to be resolved as otherwise, after solving and emerging from this financial crisis, we are only sowing the moral hazard seeds for the next one, which will be bigger and more devastating. The taxpayer is unlikely to be willing or able to help out again.