Crisis watch: still too big to fail

Informed opinion is sharply divided on how the next 12 months will play out for the global economy. Those focused on emerging markets are emphasising accelerating growth, with some forecasts projecting a 5 per cent increase in world output. Others, concerned about problems in Europe and the US, are more pessimistic, with growth projections closer to 4 per cent—and some even see a possible “double dip” recession. This is an interesting debate, but it misses the bigger picture. In response to the crisis of 2007-09, governments in most industrialised countries put in place some of the most generous bailouts ever seen for large financial institutions. Of course it is not politically correct to call them bailouts: the preferred language of policymakers is “liquidity support” or “systemic protection.” But it amounts to the same thing—when the chips were down, the most powerful governments in the world (on paper, at least) deferred to the wishes of those who had lent money to big banks. The logic was impeccable. For example, if the US hadn’t provided unconditional support to Citigroup in 2008 (under President George W Bush) and again in 2009 (under Barack Obama), the resulting financial collapse would have deepened the global recession and worsened job losses. Similarly, if the eurozone had not stepped in—with the help of the IMF—to protect Greece and its creditors in recent months, we would have faced further financial distress in Europe and perhaps beyond. In effect, there were repeated games of “chicken” between governments and major financial institutions. The governments said: “No more bailouts.” The banks said: “If you don’t bail us out, there will most likely be a second great depression.” The governments briefly pondered that prospect and then blinked. Creditors were protected and financial sectors’ losses were transferred to the domestic government (as in Ireland) or to the European Central Bank (as in Greece). Elsewhere (in the US), the losses were covered up with a great deal of regulatory “forbearance”—in other words, agreeing to look the other way while banks rebuild their capital by trading securities. And it worked—in the sense that we are now experiencing an economic recovery, albeit one with a disappointingly slow employment rebound. So why can’t we just follow a similar plan if we ever face such a crisis again? The problem is incentives. The protection that was extended to banks and other financial institutions since summer 2007 sends a simple signal: if you are “big” relative to the system, you are more likely to get generous government support when there is system-wide vulnerability. How big is “big enough” is open to question. Hedge funds are presumably looking for ways to become bigger and take on “systemic importance.” If they can do so without attracting regulatory scrutiny, no ex ante limits on their risk-taking activities will be imposed. If all goes well, the hedge funds—and the banks that are already too big to fail (TBTF)—get a great deal of upside. Of course, if anything goes wrong, everyone who is TBTF— and who has lent to TBTF outfits—can expect state aid. This expectation lowers the cost of their credit, relative to their competitors, which are small and so more likely to be allowed to fail. As a result, all financial institutions gain a powerful incentive to bulk up and borrow more in the hope of becoming bigger and so “safer” (for creditors, not for the wider world). US policymakers acknowledge that this structure of incentives is a problem—interestingly, many of their European counterparts are not yet willing even to discuss these issues openly. But the rhetoric from the White House and the treasury department is “we have ended TBTF” with financial reform legislation before congress and likely to be signed by Obama by early July. Unfortunately, this is not the case. There was a concerted effort by senators Ted Kaufman and Sherrod Brown to impose a size cap on the largest banks—very much in accordance with the spirit of the original “Volcker rule” proposed in January by Obama himself. But in an almost unbelievable volte face, for reasons that remain mysterious, Obama’s administration itself shot down this approach. “If enacted, Brown-Kaufman would have broken up the six biggest banks in America,” a senior treasury official said. “If we’d been for it, it probably would have happened. But we weren’t, so it didn’t.” Whether the world economy grows at 4 or 5 per cent matters, but it does not much affect our medium-term prospects. The US financial sector received an unconditional bailout—and is not now facing any kind of meaningful re-regulation. We are setting ourselves up for another boom based on excessive and reckless risk-taking. This can end only one way: badly.