Free Markets and Too big too fail

Free Marketers love to criticize any idea to limit the risks the big banks have taken this last decade. But Too Big Too Fail is clearly a problem. Financial institutions will continue to take risk if they believe the tax payer will bail them out. What is a free market way of solving this problem? I have a lot of respect for the brain power on this board. I’m curious to your personal thoughts on this issue. If it is not taxes and increased political regulation, is it a risk based catastrophe insurance developed independently from FDIC?

Dont allow concentration in geographic markets of big banks. There is already a law somewhere on the books about banks not being allowed to have more than a 10% concentration of deposits in any one area (dont know where I saw this) and in some geographies, they are in the 20-30% range. This concentrates borrowers as well so that their products control the prices in the local market, thereby allowing them to grow. Happened in CA with World Savings pick a pay bought by Wachovia then WF.

Prevent the GSE’s from underwriting garbage mortgages.

I won’t profess to be exceptionally knowledgeable about financial regulation, but why not address the problem of risk directly? Limit value at risk, or some other measure like that to some percentage of market capitalization. This would automatically scale risk to the size of banks, would force banks to be less risky in downturns (when their shares decrease in value), and might even solve the compensation “problem”, since banks would have to balance compensation expenses (reduces market cap and therefore risk) with reinvesting earnings in the company (increases market cap and therefore ability to take risk). This method would be fairer, more practical, and easier to implement than that stupid prop trading ban. Sure, we would need to work out fair standards to report the risk, but I don’t see how this would be more complicated than defining every single kind of trade as customer-focused or proprietary.

cfa_actuary Wrote: ------------------------------------------------------- > Free Markets and Too big too fail Free markets and too big too! (spelling) Fail.

Bring back Glass-Steagall. That would help to limit excessive risk taking to one sector of the industry. Let commercial banks lend money to homeowners and other borrowers, let other financial institutions play with derivatives, CDS’s, CDO’s etc. And also try some proper regulation of the GSE’s and the banks (both commercial and investment). I think what we have witnessed over the past decade is the prefect example of the capture hypothesis being played out in real life. Yeah I know it’s not that simple, but I only have a 5 minute break before I get back to studying commodity forwards.

When these large institutions fail…let them. When TWA failed we got Southwest Airlines and I don’t hear anyone complaining about paying lower airfares and not being charged to check their luggage :). The worst thing you can do is let these institutions make the same stupid mistakes again and chances are they will and our tax dollars will pick up the tab. If I was a manager at one of these firms I would have no problem pulling the trigger on high risk/high yield ventures because there are no consequences. More innovative and efficient firms like Southwest come about when crappy companies like TWA fail. Free markets 4 life!

NSteen1987 Wrote: ------------------------------------------------------- > When these large institutions fail…let them. > When TWA failed we got Southwest Airlines and I > don’t hear anyone complaining about paying lower > airfares and not being charged to check their > luggage :). The worst thing you can do is let > these institutions make the same stupid mistakes > again and chances are they will and our tax > dollars will pick up the tab. If I was a manager > at one of these firms I would have no problem > pulling the trigger on high risk/high yield > ventures because there are no consequences. More > innovative and efficient firms like Southwest come > about when crappy companies like TWA fail. Free > markets 4 life! But the analogy is not quite correct. When a crappy airline fails, you just fly with another, or go by bus or drive. When a major bank fails, it impacts the entire banking sector - there is no alternative to the banking sector. Airlines aren’t dependent on other airlines to the same extent that banks depend on each other.

@ newsuper I totally agree…the structure of the banking sector further complexes the issue…My point is I firmly believe we should let the markets solve these failures because there is nothing in place to stop this from happening again. Asking these banks not to take risk is like telling a kid they cant have candy in a candy store

For every monster bank that is out there, there are probably about 100 smaller community and regional banks. I’m sure they would love to be monster banks and I am sure that not all of them were taking the risks that the monster banks were taking. I’m sure they are really happy that the government stepped in to make sure that their prudence went completely unrewarded. Bottom line…there would have still been a banking sector if they let the free market play out. It just wouldn’t have been headed up by the guys with powerful friends in Washington.

Eliminating moral hazard should help.

jg1996business Wrote: ------------------------------------------------------- > > Bottom line…there would have still been a > banking sector if they let the free market play > out. It just wouldn’t have been headed up by the > guys with powerful friends in Washington. First of all, in an environment in which Wachovia, CitiGroup and Bank of America were in danger of failing, those little banks aren’t going to survive either. 140 banks were shut down last year and none of those were the so-called “monster banks”. And anyway, who do you think gives lines of credit to Microsoft? When the state of New York needs to raise capital to finance a city construction project, do they go to JP Morgan or do they go to Happy Grandma Community Bank? Retail banking is not the only kind of banking.

cfa_actuary Wrote: ------------------------------------------------------- > Free Marketers love to criticize any idea to limit > the risks the big banks have taken this last > decade. But Too Big Too Fail is clearly a problem. > Financial institutions will continue to take risk > if they believe the tax payer will bail them out. Free market capitalists, myself included, only see too-big-to-fail as a problem because the government will bail them out. It’s not a free market if there’s a government safety net. The institution best fit to regulate risk is the bank itself. But they won’t until they have to. Forcing break-ups, enacting new or old regulations, and/or government intervention in general is not the answer. They don’t exactly have the best track record do they?

Hello Mister Walrus Wrote: ------------------------------------------------------- > jg1996business Wrote: > -------------------------------------------------- > ----- > > > > Bottom line…there would have still been a > > banking sector if they let the free market play > > out. It just wouldn’t have been headed up by > the > > guys with powerful friends in Washington. > > > First of all, in an environment in which Wachovia, > CitiGroup and Bank of America were in danger of > failing, those little banks aren’t going to > survive either. 140 banks were shut down last year > and none of those were the so-called “monster > banks”. And anyway, who do you think gives lines > of credit to Microsoft? When the state of New York > needs to raise capital to finance a city > construction project, do they go to JP Morgan or > do they go to Happy Grandma Community Bank? Retail > banking is not the only kind of banking. Yes 140 Banks were shut down. They were the ones that played too close to the edge and fortunately weren’t too big to fail. That is how it should have happened for the “too big to fail banks” as well. In capitalism…you f’ up, you pay the consequences. I bet if you took away all of the banks on the planet, Microsoft…being a reasonable credit risk…would find someone to loan them money. And why the hell is it a requirement that each of these companies have to plow back every penny in their coffers into risky projects. What’s wrong with keeping cash on hand to handle emergencies so that they don’t have to keep a line of credit? And if the State of New York needs to raise capital to finance a city construction project they can put an add in the paper “Bonds for Sale!!!” Okay so maybe I am going a bit off the deep end here…

Uh what…? You just changed the subject. Everyone agrees that we need to control risk. It’s this statement that I disagree with: “Bottom line…there would have still been a banking sector if they let the free market play out. It just wouldn’t have been headed up by the guys with powerful friends in Washington.”

Community and regional banks are involved in construction projects more so than the big banks because they know the local market and values. When a big bank lends on housing irresponsibly and inflates the local real estate market, it provides an unreliable take out value of the construction loan, which can be 18 months out. When the loan comes due, then there is no take out, which we have seen alot of in the small banks that failed and didnt have access to the capital markets. Plus, from personal experience, some small banks CEOs relied on credit scores, which is not a reliable way to underwrite a commercial real estate credit. On the GSEs, they dont underwrite loans. I dont know how this misconception is still out there, they purchase loans that were underwritten by a third party and rely on the data being truthful. This still would not have stopped the bigger financial institutions, Lehman, Bear, GS, from doing the exact same thing and securitizing these assets, rating them, and selling them to unknowing investors. And in GS case, they actually bought the CDS and held them after they sold the securities leaving a short position on an asset they created with no downside exposure. Basically creating an asset they were betting would fail. Free markets? There needs to be a sheriff in town.

I believe the free market solution is to end the easy money fed policies that make the supply of capital artificially cheaper than that which our current savings rate would justify. With easy money fed policies and cheap capital banks have been able to get very large on a very shaky foundation. If we had the savings to drive down the cost of capital naturally to the levels of this decade the process of unwinding a failing giant would pose much less systemic risk because the excess leverage simply would not have existed.

^^^ That is exactly the point of Glass Steagall. This decade, peoples savings in the form of cash were sold into ARS accounts which banks cannot rely on for cheap capital, a source of tier 1 capital. People get greedy and see interest rate dollar signs so they take their low cost of funds for banks in the form of savings, checking and buy into these riskier products with artificial credit ratings. See the AG of CA Jerry Brown and his recent class action lawsuit against this practice. Bank balance sheets are very easy to read if you understand them, but the bigger banks are moving assets all over the place and hiding liabilities, contributing to unrealistically low leverage ratios.