Too big to Fail?

Is this problem confined to banks?

There was widespread concern that the taxpayer had to step in to under pin the banks because some banks had become so big that allowing one of them to fail would bring the whole system down because it would lead to panic and a run on all banks. This concern does not apply to small banks. In the United States during the current crisis, many smaller banks have gone out of business, leaving some of those who lent them money at a loss. But there was no need for the taxpayer to put his or her money on the line to stop these smaller banks going down because the losses did not pose a risk to the wider economy.

The need for intervention only arises when a bank gets too big.

Banks were getting bigger and bigger as the crisis approached. In 2005, the three largest British banks amounted to 200% of the UK’s entire GDP. By 2008, the three largest banks had grown to represent 400% of the UK GDP, a doubling in their dominance in just three years. This was true of many other countries too. Ireland has long been over dependent on two big banks and neither Irish nor EU competition policy enforcers did anything about it.

That trend created intolerable risks for the taxpayer. But it also created intolerable risks for the bankers themselves. A banker who thinks, in the back of his mind, that his bank is now so big that it will have to be bailed out because it cannot be allowed to fail , will be willing and able to take risks that his smaller competitors, who would be allowed to fail, could and would not take. Once the risks can be passed on to someone else, people become reckless. That is human nature. It is interesting to note that in the recent bubble economy, partnerships and family firms in finance, who were putting their own money on the line, have had a better record than limited liability banking corporations, where executives enjoyed upside rewards but were not personally liable for any downside losses.

Defining what is “too big” is not easy. It is an intellectual challenge. It will involve arbitrary decisions of the kind lawyers, with their unreal visions of a perfect non discriminatory world, do not like.

But it is necessary that we do it, because no bank should ever again be allowed to be too big to fail. It will involve a new approach to competition policy at national, EU, and international level . The EU has strong enough rules on what aids states can and cannot give to business, and these can be used to require the selling or hiving off of parts of banking businesses ,so that we have far more banks competing with one another .

Another way of preventing any bank becoming too dominant in a particular market would be to make it easier for banks to compete across national boundaries within the EU in offering retail banking services. This is difficult as long as EU countries have radically different and mutually unrecognisable systems for prioritizing and collecting debt, and for regulating mortgages bankruptcies and company liquidations. Cross border retail banking will also require a cross border bank deposit insurance scheme, but that would be well worth the effort ,if it gets national taxpayers off the hook of having to bail out national banks that have become too big because they face insufficient competition on their home market.

But this problem of entities in the financial world getting too big to fail is not confined to banking.

The recent report on the failure of Lehman Brothers was critical of Lehman’s auditors. As in the Enron case, the criticism focussed on off balance sheet transactions that concealed the true vulnerability of Lehman Brothers from the public and from regulators. In the Enron case the accounting firm Arthur Anderson suffered grievously for its failings. Will the same thing happen to the auditors of Lehman Brothers?

Not likely, it seems. The Financial Times reports

“Accounting experts say the Lehman report will not be an Enron for Ernst and Young, in part because with only four big accounting firms remaining, clients do not have many options to move elsewhere”

So the market, that is supposed to punish failure and reward success, cannot work properly. That situation is probably not confined to finance, although finance has special characteristics. We have seen Governments come to the rescue of their motor industry, including amazingly even motor retailers.

Part of the problem with the structure of the rescues of the banking and motor industries in the United States is that firms that were already too big are being assisted to become even bigger. eU state aid rules will hopefully prevent that happening here, but that remains to be seen.

In Irelands case, it is probable that, apart from the banks, the companies that were allowed to get too big were the property developers who were able to secure dominant positions in regard to developable land, which they hoarded . Ireland does not have a good system for monitoring this sort of development to prevent too much of a concentration of resources in too few hands, or in too few economic sectors. The Irish legal system, with its heavy emphasis on process, has weakened Irish Competition law enforcement . The law has become much more part of the problem than part of the solution.