The Fallacy of Too Big To Fail

I’ve tried to stay away from the Too Big to Fail discussion, but after doing research on the banking sector recently, I decided to put in my two cents.

First off, “too big” assumes some standard.  It assumes that something of a certain size is “good,” but when that size becomes “too” much, it becomes “bad.”  (What, like too much health, too much peace, too much prosperity, too much happiness, too much virtue?)  By what standard?  For what goal?  By whose judgment?  No data or references are provided by most of those who make this argument, which makes me suspicious right-off.

Lately, this argument has been made with respect to banks.  “XYZ Bancorp is so large that it can take down the whole financial system” seems to be the implicit line of reasoning behind the Too Big to Fail discussion.  Does that mean breaking XYZ into 10 or 100 or 1000 small banks that all fail at once is better simply because they are each small?  Are lots of small failures good and one large failure bad?  Is smallness somehow an implicit good?  No. 

I guarantee that if you break XYZ into lots of pieces that all have the same debt to equity ratios and loan exposures as XYZ as a whole, they will all fail at the same time.  And, you’ll end up in an even worse situation than if an integrated XYZ bank had failed.  Too big or small isn’t the issue, the real issue is leverage and loan exposure. 

The Too Big to Fail argument assumes that somehow lots of smaller banks will not fail at the same time but one large one will.  Oh, like lots of small banks did so much better than large banks because the housing market can’t possibly crash nationally (note: I’m being sarcastic).  Oops, that argument didn’t float.

The housing sector crashed nationally and that almost took down our financial sector and the rest of the economy for reasons other than large banks.  The banks were a symptom, not a cause. 

If banks weren’t back-stopped by the FDIC and Federal Reserve and driven to hold low equity to capital, they wouldn’t have crashed due to too much leverage. 

If home ownership weren’t explicitly supported by Congress, the Executive branch, tax policy, FHA, GNMA, Fannie Mae and Freddie Mac (government supported enterprises), etc., then all kinds of mortgage derivative instruments would never have been created and crashed.

If the government hadn’t driven the creation of rating agencies and given three of them exclusive control of debt ratings that banks, insurance companies, etc. must use in the purchasing of securities, then risky securities would never have had a huge, captive markets in the first place.

If the Federal Reserve weren’t encouraging speculation with interest rates below free market equilibrium, there never would have been massive mis-allocation of capital to the housing sector all at once.

The only thing that seems too big here is government intervention in banking, housing, debt ratings, and interest rates.

Back when banking was more free (it’s always had lots of government interference), banks carried 40% equity against 60% in liabilities.  With government back-stopping and lots of regulation, that ratio is now 10% equity to 90% liabilities (it was 7%/93% right before the financial crisis).  Perhaps things were safer when banking was more free.

The history of bank failures in the U.S. has smallness written all over it.  Our regulatory structure has long encouraged lots of small banks.  But, a small bank in Iowa is very likely to crash and depositors to be wiped out when an inevitable bad corn crop occurs.  In contrast, a large bank with loans to corn farmers in Iowa, gold miners in Nevada, cotton growers in Mississippi, steel manufacturers in Indiana, orange growers in Florida, cheese producers in Wisconsin, etc. is unlikely to have all loans default at the same time, thus protecting depositors and borrowers.

Unless, of course, speculation is encouraged on a national level, or large banks are driven to hold 10% equity to 90% in liabilities.  That doesn’t happen, though, without national coordination–in other words: without a national regulatory structure that lines up the dominoes to fall at the same time and in the same direction. 

If leverage and loan exposures were the problem, wouldn’t greater regulation of those issues fix the problem?  No.  Not all banks are the same, and so no regulatory body can foresee all the potential business mix issues that might come up (only someone omniscient could).  JPMorgan, with international operations, investment banking services, and proprietary trading operations, has very different risk exposures than U.S. Bancorp’s community banks.  You can’t come up with one-size-fits all prescriptions for either debt ratios or loan exposures.

In addition, any attempt to prevent problems is more likely to create systemic risk, because a bunch of banks marching to the same music are much more likely to fall together than several separate banks marching to their own drummer (each might fall on their own, but not together systemically).  This is the same reason why periodic recessions and small fires that burn the underbrush prevent catastrophic problems.

The road to hell is literally paved with good intentions–which frequently take the form of national (or international) regulation.

I can’t help but point out one other blatant inconsistency of the Too Big to Fail argument.  If bigness is inherently bad, then why have a BIG, super-governmental body to oversee, break-up, regulate and control banks or any other sector of the economy?  Wouldn’t its bigness be an inherent threat? 

Please keep in mind, too, that no markets in the world are as highly regulated as housing and banking, the epi-center of our latest financial crisis.  Big regulation didn’t help there.  In fact, I strongly argue it created the problem. 

When looking at bigness, it’s useful to recognize that the regulatory bodies are already much bigger and more powerful than the regulated. The Federal Reserve made $80.9 billion in “profits” last year (by trashing our currency and punishing savers, no less) compared to the two most profitable non-governmental businesses: Nestle’s $37 billion and ExxonMobil’s $30 billion.  At least Nestle and ExxonMobil produced things people wanted to buy!  I won’t even mention the ridiculous spending power of other federal government branches. 

If bigness is the problem, then banks or any other non-governmental businesses are the wrong target for concern.  But, even there, the concern is not size, per se, but what an organization does.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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The Fallacy of Too Big To Fail

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