Greenspan: “If they’re too big to fail, they’re too big”

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In speaking to the Council of Foreign Relations, Greenspan said what I have heard many other credible financial experts say, namely that financial institutions which are ‘too big to fail’ (TBTF) are simply too big.

Is this Alan Greenspan talking?  I am astonished that the man we have called bubble-blower in chief is willing to repudiate the notion of too big to fail.  I applaud him.

Here is how Bloomberg quotes Greenspan:

“If they’re too big to fail, they’re too big,” Greenspan said today. “In 1911 we broke up Standard Oil — so what happened? The individual parts became more valuable than the whole. Maybe that’s what we need to do.”

At one point, no bank was considered too big to fail, Greenspan said. That changed after the Treasury Department under then-Secretary Hank Paulson effectively nationalized Fannie Mae and Freddie Mac, and the Treasury and Fed bailed out Bear Stearns Cos. and American International Group Inc.

“It’s going to be very difficult to repair their credibility on that because when push came to shove, they didn’t stand up,” Greenspan said.

Fed officials have suggested imposing a tax or requiring higher capital ratios on larger banks to ensure the firms’ safety and reduce some of the competitive advantage from the implied subsidy. Greenspan said that won’t work.

“I don’t think merely raising the fees or capital on large institutions or taxing them is enough,” Greenspan said. “I think they’ll absorb that, they’ll work with that, and it’s totally inefficient and they’ll still be using the savings.”

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Greenspan’s comments put him on the record as more desirous of change than the Obama Administration. The Wall Street Journal accurately characterizes the Obama Administrations big regulatory proposal on TBTF institutions thusly:

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The Obama-Summers-Geithner solution — in case you haven’t studied the administration’s white paper — in Summers’ words:

  • Raise capital requirements
  • Eliminate a system where financial institutions can choose who regulates them
  • Impose rigorous standards and supervision to protect the economy and investors
  • Establish resolution authority to ensure that no financial institution is too big to fail
  • Create a unified, independent agency to protect the American consumer from fraud and abuse and ensure that people get the clear information they need about loans and other financial products.

This is a good start and I certainly like their thinking on establishing a resolution procedure for TBTF institutions. But, of course, nothing in the Obama-Summers-Geithner solution advocates the break-up of TBTF institutions. Perhaps this is because the Bush and Obama Administrations have redefined what it means to be too big to fail. 

Bill Black, who has some experience in these matters, took on this issue in a recent post on the University of Missouri-KC economics blog. He says:

The Obama administration is continuing the Bush administration policy of refusing to comply with the Prompt Corrective Action (PCA) law (see here and here). Both administrations twisted a deeply flawed doctrine – “too big to fail” – into a policy enshrining crony capitalism.

Historically, “too big to fail” was a misnomer – large, insolvent banks and S&Ls were placed in receivership and their “risk capital” (shareholders and subordinated debtholders) received nothing. That treatment is fair, minimizes the costs to the taxpayers, and minimizes “moral hazard.” “Too big to fail” meant only that they were not placed in liquidating receiverships (akin to a Chapter 7 “liquidating” bankruptcy). In this crisis, however, regulators have twisted the term into immunity. Massive insolvent banks are not placed in receivership, their senior managers are left in place, and the taxpayers secretly subsidize their risk capital. This policy is indefensible. It is also unlawful. It violates the Prompt Corrective Action law. If it is continued it will cause future crises and recurrent scandals.

I hope this solution sounds familiar because it is precisely the resolution process I advocate in my post “More on greed, regulation, Lehman and the financial industry." The point is the one Greenspan makes, namely that:

Failure is an integral part, a necessary part of a market system… If you start focusing on those who should be shrinking, it undermines growing standards of living and can even bring them down.

Let’s see what we get from Obama on this issue now that even Alan Greenspan has decided to speak out.

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