The Folly Of Regulating Mega Banks

too big to fail

Naked Capitalism has a really good post by Frank Portnoy, a professor at the University of San Diego, that discusses another aspect of the Lehman bankruptcy examiner’s report.

He points out that noboby appears able to figure out what Lehman is worth:

But an even more troubling section of the Lehman report is not Volume 3 on Repo 105. It is Volume 2, on Valuation. The Valuation section is 500 pages of utterly terrifying reading. It shows that, even eighteen months after Lehman’s collapse, no one – not the bankruptcy examiner, not Lehman’s internal valuation experts, not Ernst and Young, and certainly not the regulators – could figure out what many of Lehman’s assets and liabilities were worth. It shows Lehman was too complex to do anything but fail.

That last sentence is probably too harsh. I’d suggest that Lehman was probably not too complex to fail given tame markets. The moment that it became clear that the assets of the financial system were all suspect, became the moment that Lehman’s self-delusions about its solvency were fatal.

Before I offer a couple of opinions, consider this from his post:

Ultimately, the examiner concluded that these problems related to only a small portion of Lehman’s overall portfolio. But that conclusion was due in part to the fact that the examiner did not have the time or resources to examine many of Lehman’s positions in detail (Lehman had 900,000 derivative positions in 2008, and the examiner did not even try to value Lehman’s numerous corporate debt and equity holdings).

Nine hundred thousand derivative positions! And Lehman’s size and complexity pales in comparison to Goldman, JP Morgan, BofA and their European brethren. Do you believe that anyone, including their managers, knows the true state of their of these mega banks financial condition? More to the point, do you believe that any sort of new regulatory scheme, commitment to enhanced regulation on the part of the current crop of regulators or newly discovered commitments to better risk management within the banks is sufficient to deal with this problem?

I’ll repeat what I’ve said on other occasions. Too big to fail is not the root problem, too big to manage is. With that in mind, the most important part of any new banking regulations seems to me to be a very effective resolution authority which provides for the funds and legal authority to promptly shutter suspect banks and protect the system from the fallout that will ensue.

It’s a correct article of faith that the next crisis will arise from something different than the last one, but regardless of the source of that crisis if we continue down a course in which the soundness of a financial institution is a matter of guesswork then we can expect that this last episode and the fortune it took to stave it off might well look like child’s play.

Breaking up the behemoths is probably a political pipe dream as is truly understanding the risks they’re running and controlling that aspect of their operations. Causing a banking business that defies objective analysis of their underlying risks to underwrite potential costs of resolution need not be. We need to admit to the limits of our ability to manage the very large banks and require them to fund insurance against a repeat of the recent past.

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