Too Big To Fail Has Its Defenders

The Atlantic takes on the “Too Big To Fail” argument today and seems to reach the conclusion that financial institutions can be systemically important without being large and thus the entire discussion about downsizing the banks is moot.

Here is the author’s (his or her byline is Economics of Contempt) conclusion:

The point is that there are a number of complex, interrelated factors that make a financial institution “systematically important.” Size is one factor, but it’s hardly determinative. Other factors include an institution’s relative importance to key markets, the similarity of exposures between an institution and its counterparties, how highly leveraged an institution’s counterparties are, etc.

So why is it impossible to define “too systematically important to fail” ex ante? Because these factors are constantly in flux. The key markets–the ones where the failure of an important player could have severe knock-on effects–are especially difficult to identify in real time, because the composition of the major participants in a given market can change rapidly. In other words, the pressure points in the international financial system aren’t static. Any statutory definition would be hopelessly behind reality.

The argument here seems to be that because a financial institution is systemically important it is therefore not expendable. Survival has to be ensured due to the repercussions attendant to failure. The author discounts the possibility of a managed failure.

I know of no proponent of a new regime of smaller financial institutions who would not concede that circumstances could cause a financial institution to be managed into extinction for the sake of the system. Rather, the argument is that financial institutions and their investors (debt and equity) need to know that failure will ultimately result in the loss of their investment. Essentially, neither economic nor public concerns will stand in the way of eventual elimination of the institution as a natural result of insolvency.

That the fact a failed financial institution may have to be temporarily supported by the government as it is transitioned out of the system is irrelevant to the basic tenet that it will fail. Elimination of the TBTF mentality and protecting the system are not mutually exclusive.

The point is not necessarily to reduce the complexity of the system but to ensure that components of the system can be replaced without irreparable harm to the system. Emergency landings may be necessary but once the plane is coaxed to the ground it shouldn’t be necessary to take off again with a suspect engine.

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