Sunday, November 28, 2010

Too big to fail - a revisit

The troubles facing Ireland have brough to fore yet again an uneasy compromise policymakers and the populace had come to live with. This concerns the issue of private profits, public losses that emerged in the financial crisis. The main theme underlying the issue is the bailing out of several errant financial institutions by their respective governments during the crisis, using tax-payer's money. By not allowing these institutions to fail, the governments essentially let the owners of these companies keep the profits they made while committing the follies which drove them to the failure in the first place. The argument for doing this was that these institutions were too big to fail and letting them go through the well deserved failure would have undermined the stability of the entire financial system - with very dire repurcussions for the real economy as well. The failure of Lehman Brothers is often cited as the case in point for this. I believe part of this argument is indeed valid. I have so described in my book as well - in a box on "The Logic of Too Big to Fail".

In the short term this argument is quite acceptable. While firefighting, one does not look to punish the errant who started the fire immediately. However, this need not become the norm in the modern financial world. If financial institutions realize that they have a free hand to engage in any risk taking as long as they remain big enough (or interrelated to the rest of the financial system in complex enough ways) they will be bailed out, one does not need a crystal ball to guess what path they will choose.

In India in particular, we have the luxury of time and learning from the west's regulatory and policy mistakes. It would be a terrible waste if we ignore this phenomenon of too big to fail till a similar crisis hits us. There are various mechanisms to prevent individual companies from becoming systemically important enough to warrant a bail-out with public money. This need not smack of the relic of "Prevention of Monopolies Act". At the heart of the too big to fail argument lies the interconnections of various firms in finance. This is unlike other sectors. In finance competitors deal with each other lot more than those in any other sector. Hence any large enough firm tends to become too big to fail. The correct policy intervention here would be to make sure that the ways in which financial institutions do business with each other is adequately secure. One example is the regulation of OTC derivatives. While in theory one can argue that two firms can decide the risks they would like to take on their own books, in practice this is a sure-shot mechanism of transmitting a bankruptcy of one firm to another. More needs to be researched on this front. In general though, transperancy, promoting centralized clearing of transactions and keeping an eye on finanical sector innovations should be the general intent of policy making.

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