2008 September 20 Saturday
Prevent Banks From Being Too Big To Fail?

Steve Sailer proposes size limits on financial institutions so that they don't become too big to fail.

There is a lot of talk about how we need more governmental regulation of today's enormously complex financial markets, but the obvious problem with that is that barely anybody understands how today's enormously complex financial markets work, and those that do generally have better things to do than get paid at civil servants' salary levels.

So, what we need are a few new but simple regulations. But those are hard to come up with. Let me toss one idea out there: We shouldn't permit financial institutions to get too big to fail.

But I do not think size by itself is the problem. First off, Hank Paulson decided that Lehman Brothers could fail but AIG couldn't. Why? AIG was an insurer for lots of securities that lots of banks and other financial institutions held. If AIG failed then all that insurance would have become worthless and all those securities would have been downgraded. Then the banks would have sold those securities and took huge losses. The point here: AIG was too intertwined with other financial institutions.

So I would argue that bigger financial institutions should get saddled with more restrictions in order to limit their ability to take other institutions with them when they crash. Limit counterparty risk.

AIG's losses came in security instruments that started out with AAA ratings. Are ratings agencies the biggest causes of the financial crisis?

It now appears that a large proportion of AIG’s $41bn in writedowns stem from its exposure to so-called supersenior instruments, or the most senior chunks of pools of debt backed by mortgage and corporate bonds.

Until last summer, these instruments were considered so utterly safe and dull that they carried a triple A rating and rarely moved in price. That was because these instruments sat so high in the capital structure that they only suffer losses if a tsunami of defaults occur – and in the halcyon days before the credit crunch most investors, and rating agencies, found it impossible to imagine such a shock. However, this once-unthinkable scenario is now starting to materialise in relation to some bundles of mortgage-linked debt, causing the price of supersenior debt to fall 30 and 60 per cent, according to different measures. That has created vast mark-to-market losses at the entities holding this stuff, such as Merrill Lynch and UBS. It has also hit AIG, both in terms of securities it holds and those it has insured.

Update: A better idea: Prevent banks from buying securities that are AAA rated only as a result of being insured. Security insurance sets up the conditions of a massive failure. If the insurance agency fails then massive numbers of securities get downgraded and dumped all at once.

Share |      By Randall Parker at 2008 September 20 11:00 PM  Economics Financial

Stephen said at September 21, 2008 4:13 AM:

What's needed is something ("the remoteness rule") that prohibits the sale of a security that is too many steps removed from the original real economy object underpinning the security. For instance, borrowing for a house is one step from the underpinning economic object, the house. Two steps would be a package of mortgages. Step 3 would be some other more abstract financial instrument.

Four steps is probably enough, after that things become too abstract to determine true risk.

Thai said at September 23, 2008 8:09 PM:

I think size is an issue. There is a an equivalent law to the conservation of energy (it is actually just stating the conservation of energy another way) that says "risk is conserved". Complexity scientists have known about this for years and it can basically be stated that within a closed system, risk can neither be created nor destroyed. Eliminating risk from one part of a system simply moves it to another part of the system but overall risk remains constant.

In 'practical' terms, it means we can accept efficiency and create single structures, but in so doing we increase overall system risk when we do so. A biologic analogy would be our spinal cord. We create a more efficient transmission- communication system for our nervous system when we have one, but we also create more catastrophic consequences when they are injured.

Centralized system are more efficient (look at the way the market created Microsoft Windows). But they create more risk.

I would personally prefer smaller financial institutions

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