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‘Too big to fail’ is too dumb to keep

An excellent opinion piece by John Kay, an economist, in the Financial Times … he begins by naming the litany of institutions that were brought down in the “Credit Crisis of 2007-2009″…

He then describes the difficulty of regulating large, complex institutions with these words… “The variety of institutions is matched by the variety of regulators. The list of public agencies supervising failed businesses is much longer than the list of institutions.”

The Financial Times

~~~ “In the 2007-08 crisis, many different kinds of financial institution failed or were saved only by state intervention.

Large financial conglomerates –Citigroup and Royal Bank of Scotland.

Investment banks – Bear Stearns and Lehman.

Smaller retail banks without investment banking arms (but with active treasuries) – Northern Rock and Sachsen Landesbank.

Diversified banks, such as Fortis, and specialist lenders, such as Hypo RE.

Public agencies, such as Fannie Mae and Freddie Mac.

America’s largest insurer, AIG.

Taxpayers will be footing the bills for a generation.

All these businesses exemplified management hubris and, in almost all, the failure was the result of losses in activities that were peripheral to their core business. Otherwise they had little in common. The variety of institutions is matched by the variety of regulators. The list of public agencies supervising failed businesses is much longer than the list of institutions.

John Kay, columist

There are people who believe that, in future, better regulation, co-ordinated both domestically and internationally, will prevent such failures. The interests of consumers and the needs of the financial economy will be protected by such co-ordinated intervention, and there will never again be major calls on the public purse. There are also people who believe that pigs might fly. Mervyn King, governor of the Bank of England has made enemies by pointing out that they will not.

It is impossible for regulators to prevent business failure, and undesirable to pursue that objective. The essential dynamic of the market economy is that good businesses succeed and bad ones do not. There is a sense in which the bankruptcy of Lehman was a triumph of capitalism, not a failure. It was badly run, it employed greedy and overpaid individuals, and the services it provided were of marginal social value at best. It took risks that did not come off and went bust. That is how the market economy works.

The problem now is how to have greater stability while extricating ourselves from the “too big to fail” commitment, and taking a realistic view of the limits of regulation. “Too big to fail” exposes taxpayers to unlimited, uncontrolled liabilities. The moral hazard problem is not just that risk-taking within institutions that are too big to fail is encouraged but that private risk-monitoring of those institutions is discouraged.

Interconnected systems too complex and dangerous to fail are not unique to financial services. Failure could also have catastrophic consequences in electricity networks, oil refineries and petrochemical plants, and nuclear power stations. Interconnectedness is handled by building robust systems. If the failure of individual components might destroy the whole, systems are redesigned to eliminate the problem.

The paradox is that every financial institution has elaborate procedures to deal with a technological failure, but neither they nor the financial system as a whole has measures for organisational failure. We need to achieve that – by setting up firewalls between activities, within companies and across sectors, and by breaking down large institutions into parts so that problems of individual elements do not jeopardise the whole.

The best way to safeguard the real economy while protecting the public purse is to ensure essential financial services to individuals and businesses are regulated but to refuse to underwrite risk-taking. Some – including Martin Wolf in last Friday’s paper – argue this result could be achieved by higher capital requirements and “living wills”. If these requirements were sufficiently demanding, they would achieve the same outcomes as the separation involved in narrow banking – because they would amount to much the same thing. The capital requirements would have to be not just higher, but much higher, while an effective living will would need to ringfence retail operations and assets to enable an administrator to take them over seamlessly in a crisis.

Their activities underwritten by implicit and explicit government guarantee, it is increasingly business as usual for conglomerate banks. The politicians they lobby sound increasingly like their mouthpieces, espousing the revisionist view that the crisis was caused by bad regulation. It was not: the crisis was caused by greedy and inept bank executives who failed to control activities they did not understand. While regulators may be at fault in not having acted sufficiently vigorously, the claim that they caused the crisis is as ludicrous as the claim that crime is caused by the indolence of the police.

The governor of the Bank of England is one of the few public officials to have grasped that the primary purpose of regulation is to protect the public, both as taxpayers and users of financial services, and not to promote the interests of the financial services industry. When the next crisis hits, and it will, that frustrated public is likely to turn, not just on politicians who have been negligently lavish with public funds, or on bankers, but on the market system. What is at stake now may not just be the future of finance, but the future of capitalism.”