A Modest Proposal on To Big To Fail

To:
Mr. T. Geithner, Secretary of the Treasury
Mr. B. Bernancke, Chairman, Federal Reserve Bank

It has come to my attention that you are both struggling with the long term implications of the current Financial Institutions bailout. Namely, by stepping in to save Financial Institutions whose failure you deem to imperil the entire financial (and thereby, economic) system, you are creating an ever greater incentive for said institutions to make themselves To Big To Fail (TBTF). While the issue of Moral Hazard has already been discussed repeatedly, this issue is goes beyond that. In essence, we are in the process of creating for the largest players of our banking system an implicit 'guarantee' similar to the one that was perceived to exist for our Government Sponsored Entities' Fannie Mae and Freddie Mac. Going forward, this implicit guarantee will result in a competitive advantage for those firms viewed as being TBTF, as these firms will have cheaper access to financing, resulting in larger profits. This will ultimately lead to yet further consolidation in the Financial System, resulting in yet more entities deemed TBTF. Inevitably leading to even greater government exposure, should one of them actually fail.

There have been various suggestions of how to deal with this issue, many of which boil down to setting a ceiling on the size of financial institutions and/or increasing capitalization requirements and regulation . Both have issues. The later benefits already large and established players and penalizes small players and startups. The former forces the creation of many smaller banks and insurance companies resulting in smaller economies of scale and less well diversified firms that are more prone to individual failure. There is also the matter of strategic firms that become TBTF without really getting all that big . Some suggest we should look to the most successful piece of legislation to come out of the Great Depression, the Federal Deposit and Insurance Corporation, as a model. However, FDIC insurance coverage is limited in extant. Even so, as recent events (and the earlier S&L crisis) show, a true banking crisis results in losses so great, even well founded insurance programs cannot be expected to be sufficient. (Indeed, FDIC itself is now levying a one-time assessment on member banks , charging higher rates for riskier banks , as well as raising its rates.)

At the same time, much has been made of the inability of current regulatory agencies to keep up with the financial industry they are supposed to supervise. Yet the Congress is considering a massive increase in financial system regulations. Regulations that, where implemented, don't seem to have done much to avoid this sort of crisis. Perhaps market forces can be harnessed to do a better job.

I suggest the following:

Create an explicit government insurance agency for Counterparty Exposure. Finance this with a premiums, similar to the FDIC. That said, insurance should be broken out by both risk and total exposure - not issued on all exposure at the same rate. An unlimited but graduated insurance regime should be created instead. There should be at least 2 (and probably 3 bands). All financial institutions would be insured at the first band for their first $XXXXXXXXX of risk wieghted exposure. Over that level of exposure, they would pay at rate a higher rate. Should it be deemed advisory, (for example, should it be determined that there is a size at which systemic risk vastly increases) a still higher rate could be charged on exposures above an even higher level. The insurance would serve to partially level the playing field between the largest players and smaller institutions. The graduated rate would serve to create an advantage for smaller players, somewhat offsetting the real size related market advantages mega-banks have. That said, where size really does confer advantages of scale and diversification, we would expect to see continued increases in institutional size.

(In addition, the new insurance bands might provide an additional lever for policy makers to influence the overall economy, by raising or lowering the rates on insurance. Although how and if that should be attempted would need to be evaluated carefully.)

With counterparty exposure removed, few if any banks would ever be deemed TBTF. Moral Hazard would be reduced substantially as well. While this approach would not solve all of the problems, (in particular, it requires effective risk weighting for expsures, which has proven difficult) it would address many of them, while still allowing the market to effectively allocate capital where it would be most profitable.

Sincerely yours,

Michaelson