Tuesday, March 1, 2011

Too Big to Fail Meets Too Big to Save

The critical assumption underlying Too Big to Fail is the idea that governments will always bail out these firms if they run into trouble.

This assumption is critically flawed.  The flaw is that it assumes that governments are able to bail out these firms.

In the aftermath of the most recent credit crisis, this is no longer the case.  There is no government, including the US, that could bail out its largest financial institutions again and remain solvent.

This has important practical implications.

As Jamie Dimon said at Davos, he wanted to know who his dumbest competitor was.  Why?  So he could reduce JP Morgan's exposure to this financial institution.  This position was supported by Peter Sands and Bob Diamond.

So long as the large financial institutions realize they are now all too big to save, they all need current asset-level disclosure by their competitors so that they can manage their risk of contagion from the dumbest competitor.

The large financial institutions manage their risk of contagion by reducing their exposure to the riskiest competitor and by charging more for the exposure that they have.  Both of these put pressure on management of the 'dumbest competitor' to reduce the risk profile of the institution.

Providing current asset-level disclosure sets off a virtuous cycle.   Each time through the cycle, the riskiest large financial institution has to reduce its risk profile.

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