Dealing with the Too-Big-to-Fail

Can we hope that, in dealing with the  crisis in financial markets, US government has dodged a bullet without inadvertently lighting the fuse to fire a canon ball?

Bear Stearns was judged to be too-big-to-fail because the hard-to-predict network effects of such a failure would have been potentially devastating to the US and possibly the global economy. Therefore, the government arranged a takeover of Bear Stearns by J.P. Morgan Chase and subsidized it with taxpayer money and guarantees.

Having swallowed Bear Stearns, J.P. Morgan has grown. If either of them was too-big-to-fail then, the consequences of letting the combined entity fail would be even less acceptable.

The wizards who run and oversee the financial system permitted creation and growth of, and risk taking by private financial institutions which they knew could fail, but could not be allowed to. Then, at the brink of failure, they combined them into larger institutions subject to the same risk and logic, only at a bigger scale. This is postponing the day of reckoning with compound interest.

After a year of crisis, the world financial system is rapidly consolidating into a handful of US, European and Asian giants such as Bank of America and J.P. Morgan Chase.  In what sense, and for how long will these firms and the economy remain private and capitalistic if they can walk away with their profits, and dump their bad bets  on taxpayers?

The financial private sector can be protected from progressive nationalization by placing limits on the size of firms. Too-big-to-fail, instead of absolute size, can serve as a natural bound on how far private financial institutions are allowed by regulators to grow through organic growth, mergers or acquisitions.

The traditional rationale for intervening in the size of firms has been antitrust "to limit power and promote competition in product markets to promote economic efficiency. Government bailouts of giant financial institutions in order to safeguard the domestic and the global economy suggest another new criterion for reviewing proposed mergers and acquisitions: Will a proposed merger or acquisition create an entity which the government (US Federal Reserve System, US Treasury, European Union, or national governments in Europe as the case may be) will feel compelled to save from failure for the fear of its domino effects? If the answer to this question is yes, the proposal should be disallowed to reduce the chances that the government may have to intervene at some time in the future to save the larger combined firm.

Under this arrangement, the Federal Reserve and Treasury will review all merger and acquisition proposals to certify that they will not result in an entity that is too big to fail.

Since firms could also grow organically, the legislature could require an annual certification from the Fed and Treasury that no firm in the financial sector (defined as banking, investment banking, insurance, mutual, hedge and pension funds, and brokerage) is too big to fail. If a firm is found to have crossed that threshold, it would be required to divest itself in the manner of antitrust enforcement.

Will this leave the European and Asian giants free to crush the American pygmies in the global market place? EU, Japan and China will have to decide for themselves if adopting a similar policy to save the private financial institutions, and reaping the benefits of their efficiency, is in their best interest.

Placing the responsibility of such reviews on the Fed and the Treasury will create an incentive compatible system for these regulators; they would not be able to rush to Congress and the public exchequer when a financial firm is about to go belly up. US Congress will soon consider legislation to commit public funds to save the financial sector. This is also the only time the legislation to limit the size of financial firms can possibly be passed as a part of a rescue package. Ones the public money hss been committed, pressures from the industry lobby will make it all but impossible to achieve this end.

The short-term solutions to the current financial crisis carry the risk of setting us up for even more severe problems later. The time for establishing a mechanism to limit on the size of financial firms to protect the financial system and the public exchequer is now.