we anticipate that policymakers would face tremendous pressure to allow firms to grow large again after their initial breakup

From The Economics Of Contempt:

"Too Big to Fail" Experts on "Make Them Smaller" Idea

Gary Stern and Ron Feldman, Minneapolis Fed President and Senior Vice President, respectively, are without question the leading experts on the "too big to fail" (TBTF) issue. In 2004, they published an excellent book called, Too Big to Fail: The Hazards of Bank Bailouts. TBTF is an issue they've been thinking and writing about for many, many years.

I've argued that the "too big to fail, too big to exist" idea is ridiculous, and is "the kind of thing people say at cocktail parties to make themselves sound smart without having to do any serious work." People who think the solution to the TBTF problem is to cap bank size fundamentally misunderstand the nature of TBTF.

Stern and Feldman recently addressed this proposed solution, which they call the "make them smaller" movement. And they agree that it's only satisfying on a very superficial level:

These dynamics of firm risk-taking mean that the make-them-smaller reform offers protection with a Maginot line flavor. That is, it appears sensible and effective—even impregnable—but in fact it provides only a false sense of security that may lull policymakers into inaction on other fronts.

They make many of the same points I made, such as the disconnect between bank size and systematic importance, and the limiting effect such a hard cap would have on FDIC resolution policy. Here's Stern and Feldman on bank size as an inappropriate metric:

[S]uch a metric [asset size] will not likely capture some or perhaps many firms that pose systemic risk. Some firms that pose systemic risk are very large as measured by asset size, but others—Northern Rock and Bear Stearns, for example—are not. Other small firms that perform critical payment processing pose significant systemic risk, but would not be identified with a simple size metric. We believe that a government or public agent with substantial private information could identify firms likely to impose systemic risk, but only by looking across many metrics and making judgment calls. Policymakers cannot easily capture such underlying analytics in a simple metric used to break up the firms.

On the difficulty of maintaining a hard cap on bank size:

The dynamic challenge concerns both the ability of government to keep firms below the size threshold over time and the future decisions of firms that could increase the systemic risk they pose.

On the first point, we anticipate that policymakers would face tremendous pressure to allow firms to grow large again after their initial breakup. The pressure might come because of the limited ability to resolve relatively large financial institution failures without selling their assets to other relatively large financial firms and thereby enlarging the latter. We would also anticipate firms’ stakeholders, who could gain from bailouts due to TBTF status, putting substantial pressure on government toward reconstitution. These stakeholders will likely point to the economic benefits of larger size, and those arguments have some heft. Current academic research finds potential scale benefits in all bank size groups, including the very largest.³ (Indeed, policymakers will have to consider the loss of scale benefits when they determine the net benefits of breaking up firms in the first place.)
...
Even if policymakers could get the initial list of firms right and were able to keep the post-breakup firms small, this reform does nothing to prevent firms from engaging in behavior in the future that increases potential for spillovers and systemic risk. Newly shrunken firms could, for example, shift their portfolios to assets that suffer catastrophic losses when economic conditions fall off dramatically. As a result, creditors (including other financial firms) of the "small" firms could suffer significant enough losses to raise questions about their own solvency precisely when policymakers are worried about the state of the economy. Moreover, funding markets might question the solvency of other financial firms as a result of such an implosion.

Such spillovers prompted after-the-fact protection of financial institution creditors in the current crisis, and we believe they would do so again, all else equal. One might call on supervision and regulation to address such high-risk bets. But the rationale for the make-them-smaller reform seems dubious in the first place if such oversight were thought to work.

Stern and Feldman's longtime proposal for solving the TBTF problem is to set up a credible insolvency regime for systematically significant banks and nonbank financial institutions, funded by insurance premiums that account for firms' spillover costs.

Posted by Economics of Contempt "

Me:

Don said...

Real Time Economics also posted this:

http://blogs.wsj.com/economics/2009/03/31/another-look-at-the-too-big-to-fail-problem/

"Stern offers a three-point approach for reducing the size and scope of spillovers from a firm’s failure to prevent the need for intervention:

1) Early identification: Central banks and other bank-supervision agencies can conduct failure simulation exercises to identify problems around derivatives contracts, resolution regimes and overseas operations. One option would be to require too-big-to-fail firms to prepare documentation of their ability to enter the functional equivalent of a prepackaged bankruptcy.

2) Prompt corrective action: Bank supervisors would take actions against a bank as its capital falls below certain triggers. “Closing banks while they still have positive capital, or at most a small loss, can reduce spillovers in a fairly direct way,” he says.

3) Communication: Policymakers must communicate that creditors may be put at risk of loss."

I used to agree with this, and called my view Bagehot's Principles. But it won't work, precisely because of the very problem that they state makes limiting bank size unworkable: namely, politics:

"On the first point, we anticipate that policymakers would face tremendous pressure to allow firms to grow large again after their initial breakup."

"this reform does nothing to prevent firms from engaging in behavior in the future that increases potential for spillovers and systemic risk"

Because they understand this, they present their plan as the following:

"In that vein, we recommend three interim steps that address concerns that might lead to support for the make-them-smaller option"

I'm fine with this, being a pragmatist, and because I follow Bagehot:

"We have confidence in our preferred approach of tackling spillovers directly by putting TBTF creditors at credible risk of loss."

That's Bagehot. Onerous conditions.

"Conclusion
There is no easy solution to TBTF. Our longstanding proposal to put creditors at risk of loss by managing spillovers will prove challenging to implement effectively. Cutting firms down to size may seem easy by comparison. It is not. The high stakes of making firms smaller will make it difficult to determine which to shrink, and even then, the government will not have an easy time managing risk-taking by newly shrunken firms.We do take the aims of the make-them-smaller reform seriously and in that vein suggest options in this regard that we think would be more effective, including a spillover-related tax built on the FDIC’s current deposit insurance premiums."

I agree, that limiting size is tough, and, even if you do, risk is still in the system. That's why I now favor Narrow/Limited Banking.

I support their proposals, but we've been trying them since Bagehot. Bagehot wasn't really for his own principles, in the sense that he was not a fan of the B of E, and saw these principles as being necessary because of having a Lender of Last Resort, like the B of E.

Since we have a LOLR, which will be taken as offering an implicit guarantee to intervene in a financial crisis, it is not enough to simply try and penalize banks. We must limit their function.

Don the libertarian Democrat