By Andy Xie, May 19, 2013

BEIJING (Caixin Online) — The G-7 summit brought up too-big-to-fail (TBTF) financial institutions as a systemic risk to be addressed. The odds are low that any real reform will materialize. Removing this flaw could trigger a big global downturn. No major government has the stomach to go through with it.

The flawed global financial system essentially holds all major governments hostage. Whenever a crisis happens, the policy priority is to stabilize the financial system for short-term economic stability. This tends to favor TBTF financial institutions. Every crisis makes the problem bigger.

The vicious cycle between short-term economic stability and long-term financial risk begins with central banks easing monetary policy to stimulate growth. The systemic distortion of the price of money rewards speculation, which tends to make some financial institutions bigger and bigger over time.

True global stability will only come when major governments are willing to sacrifice short-term growth for long-term stability. That threshold will only be reached when the short-term situation is beyond repair. An inflation crisis is what it takes to change the policy dynamic.The situation needs to get worse before it gets better.

Too big to fail grows up

TBTF financial institutions were considered a key factor contributing to the 2008 global financial crisis. Five years later, the problem is worse.

 

 

While one too big to fail problem remains, another is rapidly growing. Some of the players in the shadow banking system, like hedge funds, non-bank lenders and insurance companies, have also become TBTF. If some of these players fail, the cascade effect on their investors and borrowers could lead to a systemic breakdown. Governments and central banks may be forced into bailing out some speculative outfits in the next crisis.

 

 

The surviving banks account for bigger shares of the global financial system. The lesson of Lehman Brothers is that even a mid-sized financial institution can’t be allowed to go bust. Hence, it would be unimaginable to allow any of the big banks to fail now.

While one TBTF problem remains, another is rapidly growing. Some of the players in the shadow banking system, like hedge funds, non-bank lenders and insurance companies, have also become TBTF.

If some of these players fail, the cascade effect on their investors and borrowers could lead to a systemic breakdown. Governments and central banks may be forced into bailing out some speculative outfits in the next crisis.

How could the TBTF problem become bigger? It has been in the spotlight for a long time. Most governments have been talking about reforms aimed at it. The main reason is that today’s policy goal is dominated by short-term economic impact.

Short-term economic growth has become the primary political objective in all major economies. Monetary policy is considered the cheapest instrument available. Hence, since the crisis, policies backing near zero interest rates and quantitative easing have gone mainstream.

The artificially low price of money promotes speculative activities. As speculation is highly scalable — one person could manage up to $10 billion with the same work — prolonged super-loose monetary policy inevitably leads to the rise of some successful speculators.

The scalability applies to banks too. The TBTF banks receive low-cost funding.

When the policy interest rate is 5% and the credit risk premium is 1% for big banks and 3% for small banks, the cost difference between the two isn’t too big to overcome in market competition. When the policy rate is zero, the difference becomes too big for customers to ignore. Hence, an environment of low interest rates favors TBTF banks.

So many TBTF shops

Throughout modern economic history, finance has been a fragmented business. Even the biggest names in the business had assets tiny compared to gross domestic product.

The reason is that it is a labor-intensive business. Understanding the credit risk of a borrower takes close following. Someone has to keep an eye on the borrower all the time. Hence, financial players like banks and stockbrokers tend to be regional, deriving advantage from local knowledge.

In the past quarter century, some financial institutions have become huge, qualifying as TBTF. The top ten banks in the world have assets close to one-third of global GDP.

It is unthinkable that any of the top banks would go bankrupt. If one is allowed to fail, the global economy would go into recession. Indeed, if any one of the top 100 fails, it would take down a country or two. It is difficult to see that any government or governments would tolerate that.

The shadow banking system may be more dangerous. A hedge fund can leverage up ten to twenty times through derivative instruments. Hence, a fund with $10 billion could rival the impact of one of the top 100 banks in the world. There are numerous hedge funds with over $10 billion.

The original sin

Optimal business size is in theory due to economies of scale. The automobile industry tends to have large companies because the development cost for a car is big. The big size gives a car company the ability to launch multiple models to spread risk.

Companies in the oil industry have become much bigger than before because it takes so much more to discover and develop an oil field. It is possible that some changes could turn a fragmented industry into a concentrated one. Could such changes explain the rising concentration of the financial industry?

The rise of information technology has had a big impact on the financial industry. Many top banks spend billions of dollars on information technology. Some mergers of financial institutions could be justified in cutting IT costs.

Technology is a significant contributing factor, but not the decisive one. The most important factor is Alan Greenspan. His style of monetary policy-making favored the bigness of financial institutions.

Greenspan is the father of today’s financial industry. He pioneered the policy-making of cutting interest rates aggressively in a downturn, but increasing them slowly in a recovery. The asymmetry increased money stock to GDP ratio, allowing more and more assets to be liquid and tradable. The asymmetry also subsidizes debtors with low average interest rates. Taking on debt is profitable in the Greenspan world.

Take the S&P 500 index (SNC:SPX)  as an example. It rose above 1,500 in 2000 and collapsed by half, rose above that in 2007 and collapsed by half, and has risen above that again recently. Is this normal market behavior or policy-induced fluctuation?

I think the latter. If the Fed had maintained a sensible and neutral monetary policy, the S&P 500 would have climbed slowly and now be above 1,500 without the two crises in between. The U.S. economy would be quite healthy today.