Monday, May 23, 2011

Too Big To Fail

OK, haven't posted for a while, been busy, but I was just watching HBO's Too Big to Fail, and reflecting on the whole financial crisis thing. The movie ends with a caption stating how the top 10 banks control 77% of the deposits, and they have been designated "Too Big to Fail". The presumption being that despite all of the chaos we still haven't learned anything and are continuing with the same policies.

This is to a certain extent correct, except now we have the financial system under a ridiculously complicated regulation scheme in which moral hazard is merely explicit rather than implicit, and companies are more formally protected against their business risks by the government. So basically the conflict is between letting the banks take all the risks themselves, the morally correct free market thing, and having the government regulate and guarantee them to some extent, a more practical but morally objectionable stance.

So the question really comes down to, not whether the government should do anything, since all but the most die hard Hayek devotee (of whom I am a non-diehard fan) would agree that government should do something to prevent a reoccurence. So the question is, how can we handle this systemic risk, without government control, and without the moral hazard endemic is classifying businesses "Too Big to Fail".

Unfortunately governments never take the simple solution, they would give up too much control and subtract from their whole raison d'etre. It doesn't have to be that complicated though. The simple solution is, quite simply (to be redundant) to instigate a sliding scale of capital requirements for financial institution. Banks can be as big as they want to, but their costs will simply increase the larger they get, reflecting their systematic risks. Banks already have to maintain a certain reserve ration, for example $1 of assets for every $10 they loan out. So allow this for smaller institutions, but say, for every $100 billion of liabilities that they have (in accounting terms a bank loaning out money is a liability) then this ratio increases by 10%. This will increase the costs of capital for larger insitutions, and bring banks down to a level of equilibrium which is both profitable and manageable, with no more government regulations than were required previously. In fact you could fit this entire program on a single sheet of paper.

Just an idea. Probably never get any politician to adopt it though.

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