Coming Implosion: Too Big To Fail and the Theory of Large Numbers

By Roosevelt Institute |

numbers-150Roosevelt Institute Braintruster Henry C.K. Liu examines the failure of the Obama administration to address the risky business of Too Big to Fail banks — which are getting bigger all the time.

The potential failure of banks deemed too big to fail (TBTF) presents unsolvable challenges for policymakers. Because the systemic impact of such failures on the financial, economic and social order is unacceptable, government has to intervene in a market crisis.

Thus far, official response to the TBTF threat has been focused on unlimited government protection of big bank creditors from losses they otherwise would face from big bank failures. Yet creditor expectation of TBTF protection actually encourages big banks to take more risk, thus pushing them closer to the cliff of failure. This could mean significant recurring net costs to the economy and society.

The Obama administration and Congress are now trying to address the fundamental issue of TBTF, generally acknowledged as a key contributing factor to the near collapse of the global financial system in 2008. Yet, government bailout programs for big financial institutions have resulted in banks becoming even bigger than before the crisis. Apparently, the administration’s solution to “too-big-to-fail” is to make banks bigger.

JP Morgan Chase is reportedly holding more than $1 of every $10 on deposit in the US. The four biggest super banks (JP Morgan Chase, Bank of America, Wells Fargo and Citibank) now issue one of every two mortgages and about two of every three credit cards in the US. Since the financial crisis, these four super banks are each allowed to hold more than 10% of the nation’s deposits, having been exempted from a longstanding rule barring such market dominance. In several metropolitan regions, these new super banks are now permitted to take market share beyond what the Department of Justice’s antitrust guidelines previously allow. The American banking system is now one of a handful of large global trading companies pretending to be banks, taking huge profit from high risk proprietary trades with government-backed money, instead of one of a network of small conservative local institutions serving their domicile communities merely as intermediaries of money through local deposits for nominal fees.

Sheila C. Bair, chairman of the Federal Deposit Insurance Corp, described the TBTF problem as: “It fed the crisis, and it has gotten worse because of the crisis.”

The US financial system is looking more like a financial trust of a small number of super banks operating with deliberate moral hazard backed by ever-ready government bailouts, while consumers are increasingly faced with fewer choices for financial services from competitive providers.

The Obama administration’s efforts to introduce a new regulatory regime to prevent recurring financial crises triggered by TBTF institutions leans towards imposing higher capital standards on these super financial institutions and empowering the Federal Reserve as a super regulator to take over a wider range of troubled financial firms to wind down their businesses in an orderly way with minimum loss to depositors. While adequate capital is necessary for sound banking, the problem with the banking system today is that it is infested with high risk propriety trading that the conventional bank capital requirements cannot possibly handle.

Treasury Secretary Timothy F. Geithner declares the dominant public policy imperative motivating reform as “to address the moral hazard risk created by what we did, what we had to do in the crisis to save the economy.” Yet there is little evidence that moral hazard is being reduced or the economy is being saved. What has been saved was the elite segment of the banking and financial industry at the expense of the long-term health of the economy, while moral hazard is now the accepted operative mode for super banks.

Latest FDIC data reveal that the new super banks now can borrow more cheaply than their smaller peers because creditors assume these large institutions to be fail safe. This trend will leave the financial market dominated by a gigantic trust of interlocking super banks.

Such concentration of market share will hurt consumers in two ways. It will keep cost of credit high to borrowers for lack of competition even when cost of fund for banks remains artificially low. It will also push bank reserves upward to force banks to pass on the cost to borrowers.

The White House plan as outlined so far would allow these super banks, whose failure would put the financial system and the economy at risk, to continue to exist, but would make it much more costly for them to provide financial services to the public. The plan would force such institutions to hold more funds in reserve and make it harder for them to borrow too heavily against their assets. The plan would require that these super banks come up with their own procedure to be disentangled in the event of a crisis, a plan that administration officials say ought to be made public in advance, presumably to impose market discipline on the largest and most interconnected companies. Since banks exist to make profit, the bottom line is that cost of banking services will increase for both corporate borrowers and the general public

The administration’s plan merely passes the cost of moral hazard to consumers. What need to be done is to break up these super banks and the trading firms that pretend to be banks into regional institutions separated by financial firebreaks to prevent systemic contagion, and to impose strict limits on circular hedging. But the administration and its Congressional allies continue to reject such proposals.

Mervyn King, governor of the Bank of England, and Paul A. Volcker, former Fed chairman, have separately suggested sweeping steps to force the nation’s largest financial institutions to divest their riskier affiliates. King called for the revival of Glass-Steagall, New Deal legislation that separated investment banks from commercial banks.

The solution to the “too-big-to-fail” dilemma intuitively lies in preventing institutions from getting too big. Yet because of interconnection of markets, even failure of small entities in large numbers can trigger systemic failure. This gives even entities of similar risk profile, but not too big individually, the ability to cause systemic failure.

In mathematics, the theory of large numbers includes the phenomenon of exponential growth which occurs when the growth rate of a mathematical function is exponentially proportional to the function’s current value. Such exponential growth is mathematically unsustainable and will eventually implode.

Multilevel marketing, for example, is designed to create a large marketing force by compensating not only for sales it generates, but also for the sales of the other marketing forces that each market force introduce to the company, creating a limitless down-line of distributors and a hierarchy of multiple levels of compensation in the form of a pyramid, such as that employed by Amway Corporation. The crisis in sub-prime mortgage is caused by massive network marketing, even as each subprime mortgage individually is only a small contract.

No bank, however big and well capitalized, can withstand the onslaught of a systemic breakdown of market-wide counterparty exposure built by multilevel marketing of liabilities such as subprime mortgages and their securitization.

Thus the problem of systemic market failure is caused not merely by unit bigness, but also by the absence of firebreaks to prevent unsustainable exponential growth in risk exposure and the resultant systemic contagion effect of large number failures from chained counterparty reaction. It is hard to understand why policymakers are not cognizant enough of this obvious fact to focus on the need for firebreaks in interconnected financial markets. These firebreaks are needed both prevent the buildup of risk chain reaction and to contain systemic failure contagion.

Roosevelt Institute Braintruster Henry C.K. Liu is an independent commentator on culture, economics and politics.

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