Failure Is Good

Regular readers will know that we are fans of Thomas Hoenig, president of the Kansas City Fed (see here). I was catching up on the week’s news via Calculated Risk and came across Hoenig’s recent op-ed in the Financial Times, which I recommend as a follow-up to (or shorter version of) our previous post. Nor surprisingly, Hoenig argues that large bank holding companies should be allowed to fail, meaning:

Non-viable institutions would be allowed to fail and be placed into a negotiated conservatorship or a bridge institution, with the bad assets liquidated while the remainder of the firm is operated under new management and re-privatised as soon as is feasible.

Hoenig provides a list of arguments in support of this position. He starts with moral hazard, which would not have been at the top of my list. But I particularly like these:

So-called “too big to fail” firms have been given a competitive advantage and, rather than being held accountable for their actions, they have actually been subsidised in becoming more economically and politically powerful.

As these institutions are under repair, the Federal Reserve is making loans directly to specific sectors of the economy, causing the Fed to allocate credit and take on a fiscal as well as a monetary policy role.

A systematic approach would reduce the uncertainty that has paralysed financial markets; the cost is more measurable and therefre manageable.

Here’s a link to the whole thing again.

By James Kwak

10 responses to “Failure Is Good

  1. I feel compelled to put in a word for the importance of moral hazard, as overused as the phrase is.

    If there is one lesson of the housing bubble, it is that incentives matter. When we “privatize the profits and socialize the losses”, we create incentives to increase both.

    Would you send someone to Vegas with a guarantee that you will reimburse them for any bet they lose?

    This might not be at the top of the list of problems with “too big to fail”, but it is darn close.

  2. Nemo,
    I’m with you. Over and over again we keep hearing (from the political right, anyway) that we need to let markets themselves correct their mistakes (it’s one o fthe pillar arguements against so called bank nationalization). Problem is, banks, car manufactureres, dry cleaners, you name it – none of them have incentive to self correct if moral hazard is taken off the table through any means.

    Personally, as a liberal, I would like to see moral hazard reframed as not just a balance sheet incentive, but a societal one. Then, we’d be asking ourselves whether saving too big banks is a moral hazard to the long term stability of our society, instead of the current line of inquirey.

  3. One problem with the term, “moral hazard”, is that it focuses upon the agent, who has a temptation to act imprudently. The main problem, as we have seen, is systemic. As Garrett Hardin pointed out, it is related to the tragedy of the commons. The imprudence of a few — or of many — causes disaster for all. The Too Big to Fail doctrine, articulated for banks a generation ago, is at the root of our current economic problems.

  4. Nemo has the right of it. One of the things the administration’s economists, and Obama himself, don’t seem to grasp is that the pigs come back to the trough. (Exception: Larry Summers who, with his huge conflicts of interest, shows every sign of being a pig himself.) There’s a useful analogy with the failure dysfunctional families, I think: an insider, probably but not necessarily someone who has been mistreated, will eventually speak up. That person will be ostracized and the family will explode with conflict.

    And the Senate…

  5. New Taleb paper hits on this issue from an interesting angle – disputes the purported benefits of ‘economies of scale’.

    See:”Too Big to Fail, Hidden Risks, and the Fallacy of Large Institutions”

    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1398102

  6. market.aurelius

    Hoenig is spot on when he writes: “So-called “too big to fail” firms have been given a competitive advantage and, rather than being held accountable for their actions, they have actually been subsidised in becoming more economically and politically powerful.”

    How these firms have managed to take over the entire work-out process is a mystery. They receive explicit preference (borrowing with the full faith and credit of the US govt behind their debt then using this funding to support hedge-fund-type trading … as if this hasn’t been totally discredited), and sub-rosa payoffs (i.e., the close-outs of AIG CDS exposures etc., at off-market levels) that amount to a huge covert subsidies to surviving firms that ultimately are paid out by taxpayers. Bear in mind the 1q09 “trading profits” were largely the result of the off-market AIG close-outs. Think that’s repeatable quarter after quarter? … I didn’t think so.

    http://www.inthesetimes.com/article/4361/the_meltdown_goes_global

    Some of us are of an age that we remember David Stockman saying the federal budget numbers are so huge they can’t really mean anything to us at some point. Likewise, the extent of the damage to the US and world economies: David Moberg reported (at the above link) that “(w)orldwide, according to the Asian Development Bank, the value of financial assets fell by roughly $50 trillion in 2008, equal to world output (GDP) for a year. With less wealth and a frozen credit market, business and consumer spending contracted. People lost jobs and income. Governments lost tax revenues.” These are numbers that defy comprehension. For specialists and non-specialists alike; bankers and non-bankers; Treasury officals and non-Treasury schlubs. These numbers are so huge that everyone can be absolved of blame for dragging the world into a tar pit, because none can comprehend the magnitude of what’s being said.

    What we’re living thru is the equivalent of a huge meteor hitting the Earth. Reality as we used to know it definitely will be re-ordered. But no one has even the slightest clue as to how it’s going to look. The people we all used to believe understood what was going on, and boldly took well-reasoned risks have been exposed as being wildly reckless and clueless. They have no idea what they were doing. Other than working like blazes to make sure they get paid like it’s still 2006. Why not continue to do the same thing that worked in ’06 and ’07 and, for the really slow-witted, 2008. Why not devote all your energy to repeating that you’ll get back on the good foot as soon as you are “allowed by our regulator” to repay TARP funds. Yeah … that’s the ticket.

    Right now we’re all still trying to comprehend the dust and ash that continues to fall softly to the Earth all around us. The banks, meanwhile, will continue to scurry about in this latest stage of evolution into a new feral capitalism.

  7. markets.aurelius

    Thanks for the post, Matthew. I keep feeling like we’re witnessing an evolutionary change of massive proportion right now. Taleb’s title hints at a self-organizing systems tact — and markets are self-organizing systems. In the beginning they quickly form, seemingly at random from very small and disparate pieces, into large complex systems. At some point they naturally break apart and reform into something that, post facto, appears obvious, but ex ante we can’t see unfolding.

  8. On being too big to fail: For decades we have watched these institutions merge and grow, being told that economies of scale and greater competitiveness would result to benefit one and all. Now their very bigness saves them from market forces that would otherwise see them belly-up. Sounds like time for a new, or newly enforced, anti-trust act.

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