"Too big to fail" translated means "Too big to exist"

I found Thomas Hoenig’s (president of the Federal Reserve Bank of Kansas City) comments particularly interesting. In a speech before the Pew Financial Reform Project and NY University Stern School of Business on June 27, 2011, Hoenig brings attention to the fact that no organization that has the potential to wreak havoc in the global financial markets should be allowed to exist. What do you think?

Since the global recession, the age-old term for these organisations 'too big to fail' has morphed into 'SIFI' (systemically important financial institutions). Changing names can be deceptive; it sometimes conveys the impression that the threat has gone away. Meanwhile, Basel III and regulators globally furiously juggle options as to how to protect the world from institutions that have been allowed to become so entrenched in the health of our livelihoods that any shocks to their individual businesses will likely threaten the system, as was the case in 2008. Perhaps the notion 'too big to exist' needs more airplay and discussion - I’d be very interested to hear other views!

One thing these institutions must be forced to do is break away from traditional banking services. The traditional bank function of collecting savings, transforming maturities and making simple loans in the interests of local economic growth sounds appealing if it helps to protect the stability of the economy.

Operating as a such a 'utility' would not provide the returns that banks have enjoyed in the recent past. However, their returns would be more in line with the less risky nature of their business and present a more reliable and predictable return for those investors such as superannuation funds in search of this type of asset.

The casino world of more risky financial dealings can then be left to institutions whose transparency would incur appropriate risk weightings, liquidity and capital requirements. If the appropriate level of transparency prevails it may be highly likely and beneficial that investors shy away.

Punters are busy speculating as to which institutions will be ordained 'SIFI'. As of June 2011, is appears that Australia has thus far escaped the branding. This pleased the equity markets - it means that local banks should produce a slightly higher ROE since the requisite extra capital will not be required to be tied up in lower yielding investments. Or does it?

SIFIs will no doubt enjoy a lower cost of funding since investors can bank on the fact that they will be bailed out if they get into difficulty. A 2.5% increase in capital requirements does not sound like much of a price to pay for the protection of never being allowed to fail. The talk about 'living wills' and 'orderly unwinding' of the businesses of SIFIs should they get into trouble should not be relied upon as Hoenig suggests. If history is to be believed this would eventuate into an 'orderly bailout'.

I am interested to see the outcomes of APRA’s recent request to the major banks to provide input to the development of a 'living will'. What does it suggest about the Australian regulator’s concerns about the insolvency of a major in Australia. Will a restructuring of Australian banks have any impact on the provision and costs of financial services in this country?

The dialogue on this subject continues. However, I haven’t heard much about the net benefits to households of extremely large financial institutions ... more the benefits to the shareholders.

As this subject is still being hotly debated I am interested to understand the diversity of thinking. What's your opinion?

tags: APRA, BASEL, BASEL III, GFC, recession, SIFI

One Comment

  1. Jim Seabolt
    Posted September 9, 2011 at 8:24 pm | Permalink

    Financial institutions have consolidated because of economies of scale and the operational savings that larger organizations can achieve. The trade-off is that there is a concentration of the industry, which might not yet have reached anti-competitive levels by standard measures, but the impacts from a potential failure of a larger, consolidated firm have become greater. It might be time to augment standard anti-trust reviews of industry consolidation to include the impacts to the overall economy if any of the larger firms were to need a bailout or to become insolvent. The revised cost-benefit analysis might limit further consolidation and the possible private-sector savings and efficiencies, but might also limit the public-sector impact of troubled firms and failed firms. The balancing of consolidation risks (public and private) with consolidation rewards (often private only) would be a very good thing.

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