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Too big to fail in two dimensions

By Mike Konczal

I want to lay out why I think size caps are an important supplement to the resolution authority as it is currently written in the Dodd bill in two posts. The first will be thinking about "too big to fail" in two dimensions, as if on a graph.

There is one popular argument that says that there is a myth of too big. This argument goes that the problem isn't that banks are too big, it is that we have these shadow banks, bank-like financial firms that are subject to liquidity runs. (See here if you are unfamiliar with the idea of a shadow bank run.) Even the smallest firms could be subject to a shadow bank run, and the largest firms could hold entirely cash and not be a worry at all. It's this liquidity risk that should worry us.

I want to plot out our ability to resolve a firm on two axes. The first is size of assets, the second is how risky the firm is in terms of a liquidity run. Let's plot Wells Fargo and Lehman Brothers, and then draw a green circle around them assuming that the Dodd Bill can resolve them both now.

During the crisis we lent TARP money to Wells Fargo, a large $1.2 trillion bank that is not primarily a shadow bank. We also failed to resolve Lehman Brothers, a $600 billion shadow bank. Though Lehman had excellent capital ratios when it failed, half of its liabilities were very short-term, on the order of one week, and thus were subject to a crisis of confidence in the repo market, a bank run.

Now let's plot these two in terms of the largest bank players: Here's why I don't think of "too big" as a myth for resolving a firm. In my mind, the farther you are from the origin in that graph, the harder it is for the government to detect problems and properly deter large firms under resolution authority. (This is why I draw our "safe" resolution as a circle, instead of a square.) Holding for a liquidity risk, the larger the firm, the more vicious the effects of having a shadow banking run on the rest of the financial sector and on the real economy. It is possible that the green circle here will be cast out far, and that size and pressures of campaign donations won't play a major part. But why take the chance?

-- Mike Konczal is a fellow with the Roosevelt Institute and the author of the Rortybomb blog.

By Washington Post editor  |  April 5, 2010; 8:39 AM ET
Categories:  Financial Crisis  
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Comments

I believe you mean short-term liabilities, not assets, are what put Lehman at risk of a liquidity crisis.

That said, I like the visual here. I also agree with the notion that as 'firms get further from the origin', it gets harder for the government to detect problems.

I think requiring contingent debt should be part of any financial reform - debt that would turn into equity if a financial institution was on the brink of failure. That would be a nice way to privately recapitalize the banks, while the banks have an incentive to minimize their risk to keep the cost of contingent debt low. If properly structured, a contingent debt requirement should be fairly robust to regulator failure - if the government fails to detect a problem, a financial institution has a private recapitalization plan built into its captial structure.

Posted by: justin84 | April 5, 2010 8:56 AM | Report abuse

The Interfluidity link indicates some of the problems with capital requirements, but both you and Ezra insist that such measures should be the centerpiece of financial reform. This has been bugging me for a while; could you explain?

Posted by: dgs290 | April 5, 2010 9:58 AM | Report abuse

Why is that no where in your own blog is there any consideration whatsoever of terminating all shadow banking operations from the market until there is a proper legislative scrutiny to find out exactly how to regulate and/or minimize their *cabal* mentality - ie. nonregulated financial gambits?

Posted by: hariknaidu | April 5, 2010 10:00 AM | Report abuse

This is a fascinating exercise in how to make a nonquantitative argument look quantitative. Without scales on the axes, and operational definitions of measures (especially risk of liquidity run), your graphs are meaningless. And without that, the rest of the argument is pretty pointless.

Posted by: pj_camp | April 5, 2010 1:06 PM | Report abuse

The banks and the stock market require oversight. They have robbed us blind and abused us for years. The worst part, is by removing oversight, our government let them. This has directly led to our current financial crisis and job crisis. Bring back regulation and personal responsibility to our financial agencies, such as banks and stock market.

Posted by: krissylynny | April 5, 2010 5:22 PM | Report abuse

I believe that it is time for our government to regulate the banking system and the stock markets again. They did the grand experiment of removing oversight and personal responsibility of these groups believing in trickle down economics. Instead, the American people have been legally robbed blind and left holding the financial baggage and loss of jobs and pensions (including 401k/IRA). BRING BACK REGULATION, OVERSIGHT, AND PERSONAL RESPONSIBILITY TO THE INSTITUTIONS WHO HAVE BANKRUPT AND STOLEN FROM OUR CITIZENS AND PLUNGED OUR COUNTRY IN TO RUIN!

Posted by: krissylynny | April 5, 2010 5:27 PM | Report abuse

justin84, thanks for catching that major error. The style at this blog isn't to do strike through text, so "assets" has been replaced with "liabilities." so consider this comment the updated error notice.

pj_camp, size of assets is (very close) to scale. I've been debating how to measure liquidity risk as a member of the public with only public data. Talking with some lead me to think that maybe % funding from liabilities other that core deposits. That's fairly clumpy and not totally there, but it'll probably go into the next iteration of that graph.

What I want the graph to do is to get people to think both in terms of amount of liabilities as well as a cross-section of those liabilities, especially in terms of tenor. That's probably how Basel III will approach it.

Posted by: rortybomb | April 5, 2010 8:46 PM | Report abuse

pj_camp, on the vertical axis there are several proposals that have been debated to create a real enforceable boundary. A cap of 3% of GDP for deposit liabilities (Brown Amendment in the Dodd Bill) is the one most talk about. Note that the number would not have considered Bear Stearns to be TBTF or systemically significant (since at the time of its shotgun wedding, it had about 380-390 billion in assets < 3%), and hence it is evident that you need the other axis as well. On the horizontal axis apart from liabilities other than core deposits, one could also consider a systemic variable like share of overall securities in a large wholesale market-hard data to get publicly.

Posted by: arjunjayadev | April 5, 2010 9:25 PM | Report abuse

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