As politicians go to work on re-regulating Wall Street, the guiding principle should be that no institution is too big to fail. No institution should become so important to the financial system that government must intervene in order to avoid a catastrophic collapse of the financial system in the event that it goes under.
It’s not just that it’s costly to bail out said institutions, it’s worse — it’s that counterparties to a TBTF institution believe that their dealings are risk-free, and thus the riskiest, most dangerous trades are the most profitable.
Case in point: The banks that bought CDS from AIG, basically seeing it as a free lunch to insure their entire portfolios, while knowing full well that there’s no way a company like AIG could cover the entire world.
This moral hazard question, as it turns out, isn’t a theoretical problem that folks in the do-nothing media can complain about. It’s at the core of the problem.
NYT’s David Leonhardt pulls up a great paper written by George Akerlof and Paul Romer entitled “Looting”. In it they argue that multiple financial crises can be explained by this phenomenon, the belief that a counterparty is too big to fail.
The paper can be downloaded here. Here’s the abstract:
During the 1980s, a number of unusual financial crises occurred. In Chile, for example, the financial sector collapsed, leaving the government with responsibility for extensive foreign debts. In the United States, large numbers of government-insured savings and loans became insolvent – and the government picked up the tab. In Dallas, Texas, real estate prices and construction continued to boom even after vacancies had skyrocketed, and the suffered a dramatic collapse. Also in the United States, the junk bond market, which fuelled the takeover wave, had a similar boom and bust.
In this paper, we use simple theory and direct evidence to highlight a common thread that runs through these four episodes. The theory suggests that this common thread may be relevant to other cases in which countries took on excessive foreign debt, governments had to bail out insolvent financial institutions, real estate prices increased dramatically and then fell, or new financial markets experienced a boom and bust. We describe the evidence, however, only for the cases of financial crisis in Chile, the thrift crisis in the United States, Dallas real estate and thrifts, and junk bonds.
Our theoretical analysis shows that an economic underground can come to life if firms have an incentive to go broke for profit at society’s expense (to loot) instead of to go for broke (to gamble on success). Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations.
In the end, if you take care of the too big to fail problem (not easy, we know), other stuff falls into place. You don’t have to worry about regulations on leverage, or the complexity of financial instruments, or how much CEOs are getting paid, or where they’re taking junkets, or anything else.
If no institution requires government bailouts upon its collapse, and its counterparties have no expectation of them, a lot of this stuff will fall into place.