Issue #69

Last Update October 31, 2010

Finance Too Big to Fail by Gerry Krownstein January 31, 2009 Part of the rationale for pouring public money into banks, brokerage houses, insurance companies and automobile manufacturers that are on the brink of bankruptcy due to their own managerial incompetence is that they are too big to fail; that is, a  failure of one of these firms will bring down an entire sector of the economy, harming millions who are not themselves at fault, and perhaps triggering a national or worldwide depression.

Risk is a touchy topic in the financial industry. Measuring risk accurately is difficult, and there is the tension between those that accept high risk in order to create innovation or generate higher profits, and those who want to restrict risk to protect the company from catastrophic failure. It was, in fact, a combination of lack of understanding of the risks involved in some of the newer derivatives, and greed to acquire the profits of what were, fundamentally, unsound investments, that brought down the major banks, insurance companies, and hedge funds. Any regulations imposed on these entities will run afoul of the dichotomy between creative risk and danger to the economic system.

To resolve this, I propose a regulatory rule: firms too big to fail must have their risk profile severely limited, and will be protected against failure. Firms not too big to fail can assume any risk that they want, consistent with their charter and the limits imposed by their stockholders, and are, in fact, free to fail.  When a high-risk company grows, a difficult measurement in itself, it must be tested against a too-big-to-fail limit, and if it passes that limit, it must be offered the choice between a cutback in size and a continuation in risk strategy, or growth and a change to a more cautious risk posture.These rules would apply only to financial industry firms (banking, brokerage, insurance). Manufacturing firms do not have quite the same systemic effect on the economy. Only the energy industry has a comparable effect, and energy risk is easier to measure.

How would we measure size? When does a firm become too big to fail? The essence of the financial sector is debt, either directly or in the form of derivatives, and the essence of debt is that it has two sides; the borrower and the lender. Several rules would help clarify the risk on both sides; transparency, balance sheet  visibility, and independent valuation.

1. Transparency: All financial assets and liabilities must be scheduled and categorized by type and strategy in a quarterly report to a government financial control agency. Rules for each asset and liability category must be set for quantifying risk for that category. These rules and their application will be set by the agency, which will directed to err on the side of caution.

2. Balance Sheet: Off balance sheet items are barred. This permits a more accurate estimate of the solvency of the company.

3. Valuation; All financial assets and liabilities must be valued in one of three ways; if the instrument is exchange traded, it is marked to market daily at the market closing price and a risk value assigned based on volatility; if the instrument is not exchange traded, but there is an intrinsic value that can be assigned, the intrinsic value can be used and a risk value assigned based on historic values; for those assets and liabilities not falling into one of the above two categories, the agency will assign a valuation and risk measure.

Coupled with criminal penalties for the management of any company that gets in trouble and is found to have evaded the rules, we should end up with a financial system less prone to catastrophic failure.

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