Too big to fail: is there a dangerous precedent in decreeing that a given company cannot grow beyond a certain point?

18 08 2010

I am a believer in liberalism: people should be free to act as they wish (as long as they aren’t harming anyone without informed consent).  Consequentially, I believe in capitalism- people should be free to spend their money as they wish, buy what they want and so on.

Thus banking must be allowed- if someone has money and wishes to lend it they should be allowed to do so.  They should be allowed to lend it at whatever rates they wish to whomever they wish- it’s their money.  Interestingly though, the problem of banking could be described in terms of just how “informed” the “consent” of the people at risk of being hurt is.

 The problem is not the banks, who are merely acting to achieve maximum profit, but the regulation of them- the government.  Whilst some might argue that being too stringent on them will drive them away, personally I believe that the net cost to our country will be higher if we let them stay unregulated.

 In theory- banks should be allowed to fail and people who chose to bank with e.g. an investment-cum-retail bank are taking a risk which probably rewarded them with e.g. cheaper loans/mortgages or higher interest on their savings.  I.e. people are rewarded for banking with a riskier bank, which is economically sensible.  People who aren’t willing to take the risk can earn less “reward.”

 If a large bank failed, and the government allowed this, that government would lose support from all those customers.  Thus at least one party will always support bail outs as this will get them strong support in such circumstances.  Therefore no party can support allowing large banks to fail.  Thus the only solutions are:

i)                    prevent banks from failing or
ii)                  make banks small enough to fail.

 If banks believe they will not be allowed to fail this creates moral hazard- they will act in a less risk-averse fashion than they would otherwise.  So one must try to enact a framework that makes banks highly unlikely to fail without the implication that failing banks will be supported.

 Separation of investment and retail banks would reduce the exposure of retail banks, falling into category (i).  It would also make retail banking more competitive, as “combination” banks would not have more money to play with vs their retail-only competitors and vice-versa with investment banking.  Even in this scenario however, a bank that is too-big-to-fail (TBTF) could make risky business loans or loan at unsustainable rates in the knowledge it would be bailed out.

 I think this means that- as long as the electorate will punish any government that does not save their choice of unsafe bank, banks cannot be allowed to grow so large and must be broken up.  In theory there should be no upper limit on the size of a company, however we live in a democracy not in a theoretical society and must act accordingly.  Perhaps the issue is not with democracy per se, but rather with our particular implementation of it.  I think the trick would be to explore ways of implementing democracy that do not e.g. imply by their nature that companies of a certain type must not grow beyond a certain size.