What, exactly, is it that’s too big to fail? I don’t mean “How big is too big?” I mean, what thing is it that is too big? We have been operating on the theory, I think, that the thing is an entity - that GM or Chrysler or Lehman or Merrill or AIG is too big to fail. But I think that’s a bad mistake.
As I argued in my earliest posts, what matters is the brand – the USA AAA paper brand. And if the brand is what matters, it is the brand that is too big to fail, which means that the size of the entity selling it is unimportant. And what matters to the brand is what is being sold under it. If subprime mortgages were sold only by smaller investment houses, would there have been any fewer of them, or would they simply have been spread among more distributors? What difference would it have made if the issuers were not “too big to fail”? The systemic risk would have been the same, because what has killed the credit markets is not a lack of faith in the distributors, but a lack of faith in the paper itself.
What would have happened if AIG had been allowed to collapse that would not have happened if twenty smaller companies one twentieth its size had been writing the same type of contracts? If AIG did not have the capacity it had (or thought it had) to write the CDS contracts it wrote, would no one else have issued them? AIG’s capital would have been somewhere in a world where AIG was not allowed to have it. Would that capital not have imitated the business practice of industry leaders (e.g., AIG)? If one of those twenty little firms had been allowed to fail on account of those practices, would they not all have failed? And would it have made any sense to say that one big firm would have been too big to fail, but the many doing the same thing were not, in the aggregate, too big to fail?
The major policy error being made is the failure to think existentially. Tradable Credit Default Swaps are, existentially, a bad idea. It makes no difference how like any other instrument the contracts are. A CDS allows someone to profit from the occurrence of a bad thing. No amount of technical or formal analysis can change this simple behavioral fact. Likewise, systemic risk arises because players may lose faith in the system itself. The size of entities is a detail. The question is whether the failure of any player or players of whatever size to deliver on its promises taints the system. Just how many bad bottles of Tylenol did it take to cause a panic?
Whatever we do to limit the size of entities so that they are not “too big to fail” will be irrelevant. We’ll feel better maybe, thinking that we no longer have institutions that are too big to fail, but we won’t be any safer. If our ratings agencies figure out how to rate, and investors, especially foreigners, regain their faith in those ratings, things will get better. If not, then not. And if that faith is regained, and it is then lost again, the damage will be as severe regardless of the size of the entities involved.
I suspect that the only effect we will see from “outlawing” too big to fail is that we will lose the economies of scale that come from the bigness. Otherwise, the risks will remain unchanged, exacerbated by the Government’s mistaken notion that smaller companies are not “too big to fail.”
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Paul Krugman, an excelent trailing indicator, has seen the light:
ReplyDeleteSo what’s the matter with Georgia? As I said, banks went wild, in a scene strongly reminiscent of the savings-and-loan excesses of the 1980s. High-flying bank executives aggressively expanded lending — and paid themselves lavishly — while relying heavily on “hot money” raised from outside investors rather than on their own depositors.
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And for all the concern about banks that are too big to fail, Georgia suffered, if anything, from a proliferation of small banks. Actually, the worst offenders in the lending spree tended to be relatively small start-ups that attracted customers by playing to a specific community. Thus Georgian Bank, founded in 2001, catered to the state’s elite, some of whom were entertained on the C.E.O.’s yacht and private jet. Meanwhile, Integrity Bank, founded in 2000, played up its “faith based” business model — it was featured in a 2005 Time magazine article titled “ Praying for Profits.” Both banks have now gone bust.