Too Big to Fail?

In the current financial crisis, there was widespread concern that the taxpayer had to step in to underpin the banks. Because some banks had become so big, it was feared that allowing one of them to fail would bring the whole system down because it would lead to panic and a run on all the banks.

However, this concern does not apply to small banks. In the United States during the current crisis, quite a few of the smaller banks have gone out of business, leaving some of those who lent them money at a loss.

But there was no need for the taxpayer to put his or her money on the line to stop these smaller banks from going down, because the losses did not pose a risk to the wider economy.

The need for intervention only arises when a bank gets too big.

Banks were getting bigger and bigger as the crisis approached. In 2005, the three largest British banks had assets equal to 200% of the UK's entire GDP. By 2008, the three largest banks had grown to represent 400% of the UK GDP — a doubling in their size in just three years.

This was true of many other countries too. Ireland has long been over-dependent on two big banks — and neither Irish nor EU competition policy enforcers did anything about it.

That trend created intolerable risks for the taxpayer. But it also created intolerable risks for the bankers themselves. A banker who thinks, in the back of his or her mind, that the bank is now so big that it will have to be bailed out because it cannot be allowed to fail, will be willing and able to take risks that his smaller competitors, who would be allowed to fail, could not — and would not — take.

Once the risks can be passed on to someone else, people become reckless. That is human nature. It is interesting to note that in the recent bubble economy, partnerships and family firms in finance, who were putting their own money on the line, have had a better record than limited liability banking corporations, where executives enjoyed upside rewards — but were not personally liable for any downside losses.

Defining what is "too big" is not easy. It is an intellectual challenge. It will involve arbitrary decisions of the kind lawyers, with their unreal visions of a perfect non-discriminatory world, do not like.

But it is necessary that we do it, because no bank should ever again be allowed to be too big to fail. It will involve a new approach to competition policy at the national, EU and international level. The EU has strong enough rules on what aid states can and cannot give to business, and these can be used to require the selling or hiving off of parts of banking businesses, so that we have far more banks competing with one another.

Another way of preventing any bank from becoming too dominant in a particular market would be to make it easier for banks to compete across national boundaries within the EU in offering retail banking services. This is difficult as long as EU countries have radically different and mutually unrecognizable systems for prioritizing and collecting debt — and for regulating mortgages, bankruptcies and company liquidations.

Europe-wide cross-border retail banking will also require a cross-border bank deposit insurance scheme, but that would be well worth the effort, if it gets national taxpayers off the hook of having to bail out national banks that have become too big because they face insufficient competition in their home market.

But this problem of entities in the financial world getting too big to fail is not confined to banking.

The recent report on the failure of Lehman Brothers was critical of Lehman's auditors. As in the Enron case, the criticism focused on off-balance-sheet transactions that concealed the true vulnerability of Lehman Brothers from the public and from regulators. In the Enron case, the accounting firm Arthur Andersen suffered grievously for its failings. Will the same thing happen to the auditors of Lehman Brothers?

Not likely, it seems. The Financial Times reports, "Accounting experts say the Lehman report will not be an Enron for Ernst and Young, in part because with only four big accounting firms remaining, clients do not have many options to move elsewhere."

In other words, the market — the mechanism that is supposed to punish failure and reward success — no longer has the capacity to work properly. That situation is probably not confined to finance, although finance has special characteristics. We have seen governments come to the rescue of their car industry, including amazingly even car dealers.

Part of the problem with the structure of the rescues of the banking and car industries in the United States is that firms that were already too big are being assisted to become even bigger. One can only hope that EU state aid rules will prevent that from happening in Europe — but this remains to be seen.