Too-big-to-fail is here to stay
Andrew Ross Sorkin has a slightly odd column today, asking whether it’s OK to have too-big-to-fail banks, and concluding — well, not really coming to any conclusion at all, actually.
The oddest part of Sorkin’s column is that it has all the ingredients necessary to come to the sensible conclusion: that, as he quotes Alan Greenspan as saying, “if they’re too big to fail, they’re too big”.
But Sorkin follows up with this:
It was a surprising statement from Mr. Greenspan, given his free-market comment in 2005 that “private regulation generally has proved far better at constraining excessive risk-taking than has government regulation.”
There are two problems here. Firstly, Greenspan has since recanted that belief. And secondly, the problem with having too-big-to-fail banks is not that small-enough-to-fail banks are less likely to have excessive risk-taking. As Sorkin quotes Jamie Dimon as saying, banks of any size can run into problems. But the point is that if a small-enough-to-fail bank takes too many risks and fails, the systemic consequences are manageable. If a TBTF bank takes too many risks and fails, it can drag down the entire economy.
So why allow banks to get that big? Sorkin tries, valiantly, to come up with a remotely compelling answer to the question:
Shrinking the size of these companies may create other problems for the economy, particularly in this age of huge corporations.
If Pfizer, for example, needs to raise $20 billion for a takeover bid, or Verizon needs to raise billions to lay fiber optic cable for its FiOS service, they cannot efficiently go to 20 different community banks looking for the money.
And if corporations can’t readily obtain financing in the United States, they may simply seek out huge overseas lenders like HSBC and Deutsche Bank.
The fact is that if Pfizer or Verizon need to raise billions of dollars, there are broadly three ways they can do so. They can ask an investment bank to help them raise the money in the stock market; they can ask an investment bank to help them raise the money in the bond market; or they can ask a large commercial bank to help them raise the money in the syndicated loan market.
Pfizer and Verizon are well known in the bond markets, where thousands of institutional investors trade those credits every day. And when banks enter the syndicated loan business, they rarely make significant profits from the loans themselves. Instead, the lead managers get fees for putting the deal together, and selling off most of the loan to banks which have excess liquidity and/or want to develop their relationship with the company in question.
Ultimately, however, the economy would be better off if big companies raised more equity and less debt; and borrowed what they needed to borrow in the bond market rather than the loan market, leaving the banks to do what the bond market can’t, which is lend to individuals and small businesses.
And even if that doesn’t happen, I don’t think that giving HSBC and Deutsche Bank a little bit of a boost in the international syndicated-loan league tables is a particularly high price to pay for massively reducing the systemic risk inherent in the US financial system.
Sorkin then continues:
Think of the biggest dominoes: Bear Stearns, Lehman Brothers, Merrill Lynch and Morgan Stanley. They weren’t financial supermarkets.
Mr. Dimon was trying to make this point: Companies should be allowed to be as big as they want, so long as there is an orderly way to wind them down.
Actually, Bear, Lehman, Merrill, and Morgan Stanley were all too big to fail: you don’t need to be a financial supermarket to pose a systemic risk, although it helps. And as we saw over the course of the crisis, there is no orderly way to wind down a TBTF financial institution, short of bailing it out, like we did with Fannie Mae and Freddie Mac and AIG, with billions of dollars of public funds. The likes of Jamie Dimon love to talk about “resolution authority” not because it’s a good idea or even practicable, but just because they believe (with good reason) that if they continue to talk about this chimera as though it were real, regulators might refrain from cutting them down to a manageable size.
We’ve learned the hard way that financial institutions can’t continue to operate as a going concern when the markets don’t have confidence in them any more. A confidence crisis is a liquidity crisis, and resolution authority doesn’t address liquidity concerns. If a bank is forced to default on its unsecured debt, it will fail, and it’s simply not realistic to believe otherwise. Resolution authority might protect the taxpayer from having to step up with enormous bailouts, but it doesn’t reduce systemic risk.
If you want to truly address the problem of TBTF banks, there’s only one way to do so: make them smaller. But the fact is that Jamie Dimon et al don’t need to worry about that happening any time soon. None of the financial regulations currently being debated would force them to shrink noticeably. Which means that they will continue to pose a massive risk to the global economic system for the foreseeable future.