Sunday, June 7, 2009

Too Big To Fail

I read this article in Forbes about a week ago but am just getting around to posting it. Thomas Cooley writes about the inherent dangers in accepting the 'too big to fail' rationale. The article addresses some of the same issues I have been exploring here at BadskiBlog but obviously with a lot more data.

First, the very notion of "too big to fail" is dangerous. It suggests that there is an insurance policy that says, no matter how risky your behavior, we will make sure you stay in business. It encourages banks to get bigger (or more interconnected), and it subsidizes risky behavior.

Second, it leaves ambiguous the important issue of who gets protected in the event of insolvency--the equity holders, creditors, subordinated debt holders, etc. It seems fair to say that the solutions that have developed on the fly have done severe damage to the notion that there is a well-ordered capital structure that means something.

The most crucial element of the government and free market dynamic is trust. Bailouts and the government deciding who is saved and who perishes is a slippery slope that completely undermines that confidence and trust.

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