Monday, April 28, 2008

A quick impression of Too Big To Fail

By Gary Stern and Ron Feldman (2004). The authors try to convince the reader that there are policies that can reduce the moral hazard involved in bailouts. Some banks are considered too big to fail (TBTF) and with the increase in bailouts and complexities in banking and interlinkages in payments systems and overnight loans and derivatives contracts, there has been a rise in the market expectations of bailouts.

Their recommendations are multi-pronged. They acknowledge that there is no silver bullet and that their policies will not totally eliminate TBTF expectations but should reduce them somewhat. Here are some of what I took away from reading the book. They are listed in order of how I perceived their importance to be:
1. Increase creditor monitoring by using market discipline by using the market to price the risk of banks correctly. (Appendix D goes through with some detail how they hope to achieve this.)
2. Decrease spillovers among banks. (Chapter 12 addresses payments spillovers explicityly.)
3. Reduce policy maker uncertainty over spillovers with increased supervision and regulation. The authors don't classify this as S&R but I would. There is a need for banks to increase their transparency and reporting of their positions to the authorities to allow them to perform scenario analysis and contingency planning.
4. Clarifying legal boundaries of creditors.
5. Appointing skeptical (to TBTF) policymakers.

While this is a valiant attempt to address the situation, their policy recommendations are more or less a mish mash of unrealistic recommendations or policies that are already under consideration by the Fed, Treasury, G10 and BIS. I consider increased creditor monitoring to be the most unrealistic - the principal agent literature indicates that this is a hard problem - and without addressing the underlying capital structure of the bank/financial institutions the recommendation glosses over these difficulties.

I am probably unfair in making the claim that the authors consider this to be the most important recommendation. They don't actually say so in the book and to be fair they acknowledge that there are limitations to this method which is why it needs to be considered in total with all the other policies. In other words, they are listing a set of necessary (but not sufficient) policies to address TBTF.

Some passages that struck me as I was reading:
1. In light of the recent sub-prime events, page 51:
... we consider the discount window and possiby open market operations, as potentially effective tools for managing the threat from a failing bank. Nonetheless, on several occassions in the past, policymakers did bit avail themselves of such tools, ...
[I would think that the authors would thus be at least encouraged that the Fed did try these tools recently]
2. Figure 6-1 on page 62 was surprising to me. In 1998/1999, the share of bank assets held by the 10 largest banks in the US (approx 40%) was surpassed by Canada, Australia, Belgium, France, Netherlands, and Sweden (approx 90%), Japan, Italy, Spain, UK (approx 60%). The source of this chart was a Group of 10 report "Report of Consolidation in the Financial Sector" (2001).

Finally, some thoughts on TBTF from William Poole via Mish's Global Economic Analysis.

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