The Knowledge Exchange / Risk Management / How big is “too big to fail?” – Part 2

How big is “too big to fail?” – Part 2

The second of a two-part series on the “too big to fail” debate

Part 2:  Bank innovation and regulatory influence

Since the most recent global financial crisis, public policy has been moving toward limiting the size of financial institutions, presumably so that they do not become too big to fail.  The moniker, “too big to fail,” has come to mean that precipice where banks warrant government bail-outs and subsidies in order to stop collapse.  Proposed regulation (such as taxation and bank fees), designed as punishment for those whose inappropriate risk-taking activities required government rescue could cause financial market suspension and curtailed bank innovation, hurting an already-wounded global economy.  Credible resolution comes from applying market forces to capital regimes that reward financial institutions for managing their risks – including systemic risks – responsibly.

Market forces should correct for a less-than-perfect regulatory environment while preventing banks from taking inappropriate risk-taking activities.  But here’s the catch:  the greater the systemic importance of a bank, the higher the probability that bank will be rescued by its government.  History tells us that regulators—those charged with setting and enforcing limits—support the credit of “systemically-important financial institutions” (SIFIs) even as they become insolvent, effectively creating the too-big-to-fail problem.  If a bank is not subject to the consequences of inappropriate risk-taking activities, it has no limit to size, complexity, or interconnectedness.  A government bail-out turns into a taxpayer put option, not allowing an institution to fail or be responsible for inappropriate risk-taking due to overt risk mismanagement or ignorance (defined as lack of information or records).

Capital regulation may have contributed to the level of systemic risk experienced during the financial crisis.  By requiring capital to be held for traditional bank activities but not for an ever-growing and more risky portfolio of products, capital regulation redirected bank practices to non-traditional activities.  Additionally, the regulatory framework under which banks operate regulates SIFIs differently than non-SIFIs and of course, did not cover non-regulated firms.  This uneven, discriminatory framework caused the subprime crisis because risk capital held for mortgages in commercial banks was not required in financial units of non-financial institutions.

Additionally, given changes in regulation, we cannot be assured that we can avert another crisis in the future.  Financial markets are incomplete and their intermediaries, in response to regulatory limits and market changes, will continue to evolve.  As such, value-creation should not be demonized but rewarded when risk-taking activities are appropriate and have the correct amount of capital attached as protection against failure.

Download both of these free white papers : The Art of Balancing Risk and Reward and Society, Shareholders and Self-Interest: Accountability of Business Leaders in the Financial Services. This research delves into the need for financial organizations to create a balance between risk management and the need to make a profit and keep their commitments to shareholders while protecting their customers.

References:

Castellano, Giuliano. “Governing Ignorance: Emerging Catastrophic Risks—Industry Responses and Policy Frictions.” Geneva Papers on Risk & Insurance – Issues & Practice 35.3 (2010): 391-415.
De la Torre, Augusto, and Alain Ize. “Containing Systemic Risk: Paradigm-Based Perspectives on Regulatory Reform.” Economia 11.1 (2010): 25-52.
Jackson, James K. “Financial Market Supervision: European Perspectives.” Current Politics & Economics of Europe 22.2/3 (2011): 291-325.
Sharfman, Bernard S. “Using the Law to Reduce Systemic Risk.” Journal of Corporation Law 36.3 (2011): 607-34.
Slovik, Patrick. “Systemically Important Banks and Capital Regulation Challenges.” France: OECD Publishing, 2011. 18 of OECD Economics Department Working Papers.

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