Why are Too-Big-To-Fail Banks so Bad?

Simon Johnson (professor at M.I.T.’s Sloan School of management, former chief economist at the International Monetary Fund, and author of the book 13 Bankers) explains very eloquently why having too-big-to-fail banks is bad for the economy and why we must end too-big-to-fail banks.

Simon Johnson writes about the effect too-big-to-fail banks have on our economy and in the financial system.

If you are “too big to fail” (T.B.T.F.), credit markets see you as lower risk and as a more attractive investment — enabling you to obtain more financing on cheaper terms, and thus become even larger.

Everyone agrees, in principle, that this is a bad arrangement.  It’s an unfair distortion of markets, giving huge banks the opportunity to grow bigger, because they have implicit government guarantees.  It is also manifestly unsafe, because it encourages reckless risk-taking: If things go well, the T.B.T.F. bank gets the upside; if there is mismanagement of risk, or just bad luck, the downside falls to the taxpayer and to society more broadly.  These costs can be huge: eight million jobs lost since December 2007.

Three main views on how to end too-big-to-fail banks.

First view.

The view of Senator Christopher J. Dodd, the Democratic Congressional leadership more broadly and the White House — and actually the big banks themselves (e.g., Jamie Dimon in The Wall Street Journal on Wednesday) —  is that the creation of a “resolution authority” would, at a stroke, effectively remove the perception and the reality that some banks are too big to fail.

How would this work?

Federal Deposit Insurance Corporation, the F.D.I.C. (or potentially another agency) would expand the powers it currently has to “resolve” — i.e., take over and liquidate in an orderly manner — banks with federally insured deposits; in the future, it could do this for any financial institution.

Second view-counterarguments by Republicans.

Senator Richard Shelby (ranking Republican on the Senate Finance Committee), is that we should just allow big financial firms to fail outright, i.e., to run through the usual bankruptcy procedures.

At a rhetorical level, “let ‘em fail” has some appeal.  But as a practical matter, it is a complete nonstarter.  Remember… Lehman fail in September 2008, credit markets immediately choked and the global economy teetered on the brink of a second Great Depression.

When another megabank starts to melt down, any future president, no matter how libertarian or interventionist by inclination, will face the same horrible moment of decision: let the financial system collapse, or provide an expensive rescue.

Third view….and according to Simon Johnson the best option to breaking up too-big-to-fail banks.

Senate by Ted Kaufman, Democrat of Delaware, is much simpler and more direct: break up these megabanks.  As even Alan Greenspan said in October 2009, “If they’re too big to fail, they’re too big.”….

For more on Senator Kaufman’s SAFE Banking Act.

Now breaking up too-big-to-fail banks is not the only necessary action that needs to be taken to shore up our countries financial industry. We must also have higher capital requirements, more transparency for derivatives and generally more effective regulation, according to Simon Johnson.

To read more of Simon Johnson’s writing on financial regulation go to the Baseline Scenario . You can also find him along with other financial experts at the Econmix blog on the New York Times website.


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Published in: on April 22, 2010 at 4:06 pm  Leave a Comment  
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