Tuesday, December 1, 2009

Too big to fail

Due the financial crisis two questions has become repeatedly asked. Are some financial institutions too big to let them bankrupt? Do governments have to bailout financial institutions?

On one hand it is true that the spillover effects of a big bankruptcy could be disastrous for the national financial system and at the end all the economy. Even thought, a NYTimes article argued that bigger financial institutions have become a historical process and there is no turning back. Moreover, he argues, it wouldn’t be any easy to impose limits to banks.

But the truth is that first, if governments bailout financiers, those big enough will have an incentive to become over leveraged. And second and more important, something wrong exists in financial systems that when they are freely auto controlled they become unstable. This is well explained on a piece from Sharyn OHalloran, on March 11th 2009, where she exposes the coincidences between the tragedy of Commons wrote in 1968 by Garrett Hardin and the Financial system. In its origins the tragedy of Commons is a 19th century phenomenon. English cows, sheep, pigs and other livestock grazed on the commons (shared pastures which anyone could use). But the commons were always depleted, with barely enough grass to everyone’s detriment. Everyone would be better off if fewer animals graze on the commons, but each individual user has incentives to increase the size of his herd past the socially efficient point. Beyond this social efficient point, gains and only for the individual and costs are share by all. So individuals have an incentive to exceed the socially efficient point. The same happens to financial systems. When people become over confident on the economic situation they want to get into debt. Banks in order to respond extend new and greater credits. Each bank is better off extending this new credits and avoiding the rest to get it, but the whole system as the commons in 19th century is worse, too risky. This failure is also implicit in prisoner’s dilemma, telling the other is guilty makes you free but telling both other’s guilt makes their situation worst. What about if a bank, knowing this, waits until the storm pass through? As a consultancy exposed during the crisis: or you play the game or your clients won’t accept your less returns and at the end you will be forced to close down.

The solution proposed by 19th century herdsman was to assign private rights to grazing land but no barrier would be enough to separate financial world from real economy. Solutions are not easy, but necessary. An article from The Economist (23rd Nov.) pointed two papers having a proposition: ‘The role of macroprudential policy’ and ‘The Warwick Commission on International Financial Reform’.

So, we said that to fix these bailout problems, first, financial system must be regulated and second something must be done with incentives behind ‘too big banks’. One would say that big banks are necessary but an empirical study (very few there are) from T.Beck, R. Levine et.al. in 2005 conclude that while there is a link between bank concentration systems and and less risk of financial systemic crisis, the also positive relation between competitiveness an banking stability suggests that “bank concentration is an insufficient measure of bank competitiveness” and therefore insufficient to measure risk probabilities.

Finally, we know that systemic financial crises are produced by a under regulated systems but we don’t know how to fix it properly (at least consensus is far away) neither if we have to bailout big banks. What is clear is once done, once a big bank is bailout we should demand for considerations towards the society.

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