Too big to fail is too big

The too big to fail problem has been central to the degeneration and corruption of the financial system in the north Atlantic region over the past two decades. The ‘too large to fail’ category is sometimes extended to become the ‘too big to fail’, ‘too interconnected to fail’, ‘too complex to fail’ and ‘too international’ to fail problem, but the real issue is size.  The real issue is size.  Even if a financial business is highly interconnected, that is, if its total exposure to the rest of the world and the exposure of the rest of the world to the financial entity are complex and far-reaching, it can still be allowed to fail if the total amounts involved are small.  A complex but small business is no threat to systemic stability; neither is a highly international but small business.  Size is the core of the problem; the other dimensions (interconnectedness, complexity and international linkages) only matter (and indeed worsen the instability problem) if the institution in question is big.  So how do we prevent banks and other financial businesses from becoming too large to fail?

Remedies for too big to fail

(1) Become too big to save

In a few cases, banks have been not just too big to fail, but also too big to save.  The fiscal spare capacity of the state that ultimately backs the financial institutions deemed too big to fail turned out to be insufficient to save them.  This happened in Iceland in September-October 2008.  The four international banks of Iceland now have all defaulted on their debts.  It could happen in other places.  Anne Sibert and I have pointed to the dangers of the ‘inconsistent quartet’: a small open economy with a large internationally exposed sector, its own ‘small’ non-global reserve currency and limited fiscal spare capacity.  Apart from Iceland, which imploded, this category includes Switzerland and possibly the UK.  Ireland, the Netherlands and Belgium have 3 of the four inconsistent characteristics.  But for their membership in the Euro Area, their banking systems might have been toast already.  For the -US banks and most Euro Area banks, the banks top managers and boards know, however, that they are too big to fail but not too big to save.  And they play that card for all it is worth to extract the maximum amount of resources from the hapless tax payer.

(2) Restore narrow banking or public utility banking

Public utility banking’ with just retail deposits on the liability side and with reserves, sovereign debt instruments and bank loans (secured and unsecured) on the asset side would take care of the retail payment, clearing and settlement system and deposit banking.  Such narrow banking would represent an extreme version of Glass-Steagall approach.  There would be deposit insurance and, should that fail, a lender of last resort and market maker of last resort.  These tightly regulated institutions would not be able to engage in other banking and financial activities, and other financial institutions would not be able to take deposits withdrawable on demand or economically equivalent instruments.

These public utility banks could be publicly owned or privately owned, or could be managed through mutual arrangements (like the UK building societies or the Dutch Rabo Bank) or through cooperatives.  Where the public utility bank is publicly owned, I would hope its management would be contracted out to a properly incentivised private concessionaire.  Civil servants make lousy loan officer

From the horror stories that have come out of at least five of the seven German Landesbanken, it is clear that public ownership and control is no guarantee for sound banking.  They were brought down by two developments.  The old and familiar problem was that they were pushed by cash-strapped Länder governments to engage in politically popular but financially non-viable regional projects.  The second problem was that, far from remaining narrow banks, these Landesbanken engaged, sometimes through off-balance sheet vehicles, in increasingly reckless investment bank behaviour, including investing in financial instruments they did not understand.  The problems of the German Landesbanken are mirrored in the disastrous shape many of the Spanish Cajas, mutually owned, co-operatively owned or owned or controlled by local or regional authorities, find themselves in.

Narrow banking or public utility banking would, be a key part of a safer and less morally hazardous banking system

(3) Create mono-product central counterparties and providers of custodial services, central wholesale and securities payment, clearing and settlement platforms

We cannot have essential financial infrastructure services provided by unregulated or lightly regulated profit-seeking private enterprises that may be engaged in a variety of other financial activities, many of them high risk, as well.  The entities that provide these services have to be treated and regulated as public utilities.  This includes the wholesale (interbank) payments, clearing and settlement systems (TARGET, in the Euro Area).  It also includes the securities clearing and settlement systems and the custodial services essential to their performance (TARGET2 Securities in the Euro Area).  The tripartite and quadripartite repo system is included.

If these services are to continue to be privately provided, the firms engaged in their provision should be strictly regulated and restricted to perform just the regulated tasks.  There should be also be redundancy: for operational security reasons, there should be at least two physically, administratively and legally separate and independent providers of the entire suite of systemically essential services.  There is no reason why the central bank would provide any of these services, although it could.  Whatever entity provides these services should have open-ended and uncapped access to central bank liquidity, guaranteed by the Treasury.

What constitutes essential financial infrastructure services will change over time.  In view of the problems created by the opaque over-the-counter markets in certain kinds of derivatives (e.g. credit default swaps (CDS)), centralized trading platforms, perhaps with a market maker of last resort, and with transparent clearing, settlement and custodial services-providing rules and arrangements will have to be created for many of these derivatives.  These platforms should be viewed and regulated as public utilities.

(4) Keep a lid on the size of investment banks

Let’s call all other activities currently undertaken by the banking sector and the shadow banking sector will be called investment banking activities.  It might seem that, since the products, services and instruments created exclusively by the investment banking sector are not systemically important, these investment banks could be left to play by the normal rules of the market game, with little if any regulation.

Unfortunately, this is not the case.  Financial instruments that are not systemically important if a few trillion US dollars worth of them are outstanding, become systemically important when, as in the case of CDS at their peak, $60 trillion worth of gross notional exposure is outstanding.   Pure investment banks, even if they have been stripped of their ‘infrastructure services providing (including counterparty) roles, can be too large to fail. What is to be done about them.

(5) Tax bank size

When size creates externalities, do what you would do with any negative externality: tax it.

The other way to limit size is to tax size.  This can be done through capital requirements that are progressive in the size of the business (as measured by value added, the size of the balance sheet or some other metric).  Such measures for preventing the New Darwinism of the survival of the fattest and the politically best connected should be distinguished from regulatory interventions based on the narrow leverage ratio aimed at regulating risk (regardless of size, except for a de minimis lower limit).

(6) Use competition policy

Strict and aggressive competition policy is another way to reduce size.  Large banks can be broken up in a variety of ways (vertically, that is, by activities or products) or horizontally, that is, by splitting a given activity or the supply of a given product of service among several independent legal entities.  The crisis and contraction are delivering the opposite outcome.  There are fewer banks and market concentration is increasing everywhere.  In the UK, competition among banks in the high street is going to be materially diminished by the acquisition of HBOS by Lloyds-TSB.  With Bear Stearns, Lehman Brothers and Merrill Lynch gone as independent investment banks, concentration and monopoly power in the investment banking market has exploded.

Are mega-banks necessary for efficiency?

Would there be significant efficiency losses as a result of breaking up banks and taxing bank size?

What would be the social cost of taxing size in banking and other financial businesses and of breaking up banks? Why do banks and other financial enterprises become too big to fail?  I believe there are four reasons

(1)   The exploitation of monopoly power (market power).

(2)   The exploitation of ‘synergies of conflict of interest’.

(3)   The exploitation of economies of scale and economies of scope.

(4)   The joys of being too big to fail and the implicit subsidy provided by the tax payer guaranteeing the bank against default and insolvency.

The pursuit of the benefits of subsidized liquidity and solvency support from the state clearly makes sense for the bank’s top management and board, for shareholders and for unsecured creditors: being too big, too interconnected, too complex and too international to fail is a major business asset.

The universal banks that dominate the European banking scene and much of cross-border banking are now also increasingly dominant in the USA, exist for three of the four reasons outlined above – all but the third.  Economies of scale and scope have long been exhausted and diseconomies of span of control compete with lack of focus as the main drivers of organisational inefficiency.  But by bundling the systemically important activities with the not systemically important activities, the entire organisation falls under the government’s bail-out umbrella.  It is time to see a lot more and a lot smaller banks.

For the time being, banks that are too big, to interconnected, too complex or too international to fail are bound to be with us.  For those I would support a proposal made by Raghuram Rajan and by Richard Herring, that such institutions be required to develop a bankruptcy contingency plan that would lay out how they would resolve themselves quickly and efficiently.  Such a “shelf bankruptcy” plan would require banks to track and document their exposures much more carefully than they do now and in a timely manner. An insolvency plan is just as vital as a business plan for a financial institution in the too big to fail category.  As Governor Mervyn King said in his 2009 Mansion House speech: everyone should have a will, including banks.

(7) Restrict limited liability to prevent excessive risk taking and reduce the size of banks

Incentives for excessive risk taking take many forms.  An obvious one is limited liability.  With limited liability, an investor (shareholder) can at most lose the value of his investment.  The non-linearity in the pay-off function for the shareholder this creates, encourages placing more risky bets: losses beyond a certain magnitude are not born by the shareholder.  Gains of any size are appropriated by the shareholders.

The combination of limited liability and leverage means that bets of almost any size can be placed by investors with this distorted, asymmetric payoff function.  This can be done through conventional leverage (borrowing) or through leverage embedded in derivative contracts.  A simple way to mitigate this problem is not to permit highly leveraged financial institutions (other than tightly regulated narrow banks, insurance companies and pension funds) to be limited liability companies.  Instead, partnerships and other forms of unlimited, joint and several liability should be required.  Partnerships and similar arrangements were the norm for investment banks until the 1990s.  It is worth considering the removal of limited liability protection from highly leveraged financial entities with considerable asset-liability mismatch.   This would no doubt also help keep down their size, by any metric of size.

(8) Create effective special resolution mechanisms for all systemically important financial institutions

Failure of a systemically important financial institution, that is default on its debt or insolvency, is a no-no because under most past bank restructuring and insolvency procedures, it has meant the destruction or at least the serious impairment of the insolvent financial institution as an organisation.  There is no reason why a bank or other financial institution could not continue to perform, without any interruption, its systemically important functions at the same time that the Administrator/Conservator of the special resolution regime (SRR) for this bank or ofi informs the unsecured creditors that they have become shareholders.  Resolving the legal issue of insolvency of a bank should not, in an merely minimally intelligently designed legal and regulatory structure, mean the collapse of the organisation or even its paralysis for a single instant.

There has to be absolute clarity about the seniority of the different classes of unsecured creditors (which is another reason for taking the tripartite and quadripartite repos out of the banks), but once the seniority ranking of all the unsecured creditors is established unambiguously, restructuring an insolvent financial institution and recapitalising it out of the claims on the banks held by the unsecured creditors, need take no time at all.

The insolvent bank could continue to engage in new lending and new borrowing (perhaps with the new flows even guaranteed by the state) at the same time that the old unsecured creditors are taken to the cleaners, by having their claims written down or converted into ordinary equity.

Conclusion

In banking and most highly leveraged finance, size is a social bad.  Fortunately, there is quite a list of effective instruments for cutting leveraged finance down to size.

  • Legally and institutionally, unbundle narrow banking and investment banking (Glass Steagall-on-steroids).
  • Legally and institutionally prevent all banks (narrow banks and investment banks) from engaging in activities that present manifest potential conflicts of interest. This means no more universal banks and similar financial supermarkets.
  • Limit the size of all banks by making regulatory capital ratios an increasing function of bank size.
  • Enforce competition policy aggressively in the banking sector, by breaking up banks if necessary.
  • Require any remaining systemically important banks to produce a detailed annual bankruptcy contingency plan.
  • Only permit limited liability for narrow banks/public utility banks.
  • Create a highly efficient special resolution regime for all systemically important financial institutions. This SRR will permit an omnipotent Conservator/Administrator to financially restructure the failing institutions (by writing down the claims of the unsecured creditors or mandatorily converting them into equity), without interfering materially with new lending, investment and funding operations.

The Geithner plan for restructuring US regulation is silent on the too big to fail problem.  That alone is sufficient to ensure that it will fail to result in a more stable and safer US banking and financial system.

In the UK, the otherwise enlightened head of the FSA, Adair Turner, does not see a problem with banks of huge size and with a staggering range of unrelated or conflicted activities.  Of all the parties that matter, only the Governor of the Bank of England, Mervyn King, is clear that ‘too big to fail’ is at the heart of the financial crisis we are trying to exit and will be at the heart of the next financial crisis that we are preparing so assiduously.

The Chancellor of the Exchequer, Alistair Darling takes the cake in the bigger is better stakes.  He appointed “Win” Bischoff, the former chairman of Citigroup (appointed interim CEO for Citigroup in December 2007 after Chuck Prince bit the dust), to co-chair the writing of a report on UK international financial services – the future, published on May 7, 2009.  That’s rather like asking the Ayatollah Ali Khamenei to write a report on who won the Iranian presidential election.  It really is the most ridiculous appointment since Caligula appointed his favourite horse a consul.  You will not be surprised to hear that the report does not consider the size of UK banks to be excessive.

International cooperation is necessary if we are to solve the too big to fail problem.  I am not holding my breath.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website

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