Wednesday, January 30, 2013

How to put the Too Big to Fail genie back in the bottle

To date, the two primary methods discussed for putting the Too Big to Fail genie back in the bottle are to either break them up by regulatory fiat or subject them to a super-sized dose of the combination of complex rules and regulatory oversight.

There is a third way:  subject them to market discipline and let them shrink themselves as a result.

Subjecting the TBTF to market discipline requires adopting the FDR Framework as it applies to banks.

  • First, the global financial institutions must provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.
  • Second, any remaining financial crisis programs like regulatory forbearance and suspension of mark-to-market accounting need to be ended.

With ultra transparency, market participants are given access to all the useful, relevant information in an appropriate, timely manner for independently assessing and making a fully informed decision.

With the ending of the financial crisis programs, market participants are reminded that going forward they are responsible for all losses that are incurred on their exposures to the TBTF.

Knowing that they are responsible for losses on their exposures to the the TBTF, market participants will assess the risks that the TBTF are taking and adjust the return they require on their exposures to the TBTF to reflect this risk.

Sources of risk that will drive up the return investors require include complexity (think all those subsidiaries engaged in regulatory or tax arbitrage), proprietary trading (gambling is risky business) and interconnectedness with other financial institutions (no investor wants to lose their money because a dumb competitor blows up).

Faced with a much higher cost of capital and lower share price, management of the TBTF will be under pressure (i.e., market discipline) to reduce the risk and complexity of their institutions.

How they reduce the risk and complexity is their choice.  The point is the result will be a much lower risk and less complex financial institution that, while it is unlikely to fail, could in theory fail without bringing down the financial system.

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