Too Small To Succeed

Posted Apr 20, 2016 at 10:21. Revised Aug 14, 2019 at 08:17.

It seems that the current political environment has brought politicians out of the woodwork, promising to break up financial institutions that are “Too Big to Fail.” The argument for ensuring that no bank or insurance company is “too big to fail” is sublimely simple. All financial institutions should be small enough so that when an individual institution fails the failure will not need a public funds bailout. Small failures would not infect or damage other institutions. This view ignores a financial disaster that hits everyone at once, which sometimes happens.

One can hardly argue against the intent behind keeping institutions small. Unfortunately, financial companies are more complex than they look, and there is much more to running a financial organization than one might think. For at least 200 years bankers have understood that financial dealings can sometimes go sour despite all efforts to handle them carefully and responsibly. They have also been quite aware that if enough things go wrong at the same time, those unfortunate events can sink a financial organization.

Interestingly, most people in Canada are probably more worried about a bank’s being too small to succeed, for reasons discussed later. Five big banks essentially make up the Canadian banking system. For instance, if the Royal Bank of Canada and the Bank of Montreal were to fail at the same time, a national financial crisis would ensue immediately. So why aren’t Canadians in a state of panic over this? There is an answer, but later.

From the beginning, a prudent banker was careful about lending money because if his bank failed, he went down with it. Good banking practice avoids lending too much money to any one customer and lends only to customers who can repay the loan. Unfortunately, there will always be unexpected circumstances that make a customer unable to repay his loan. A prudently run bank can handle such a loss without being pushed under because a single bad loan will be only a small part of all the institution’s assets.

Prudent bankers have also understood that a competitor’s failure is nothing to gloat over because the failure of a bank hurts the wider community. The bad loan will directly and indirectly hurt other banks as well. Because of this, banks long ago took the first step toward a complexity trap by agreeing that they would make funds available to their competitors when one of them needed a temporary bailout. Such arrangements make a town’s banks collectively stronger and safer.

Unfortunately, such arrangements make things worse when a community-wide disaster leaves many creditworthy customers unable to pay back their loans. For instance, in a farming community crop failures could make many responsible farmers unable to repay their loans. Such events would stress all the town’s banks and make each bank unable to help out the other banks. Guarantees among local banks are not adequate to handle a community-wide catastrophe.

The next step to spread the risk would include larger city banks in the mutual support arrangements, which is reasonable in most circumstances. Historically the smaller banks often deposited some reserves in a bigger city bank as an extra preparation for a rainy day. These reserve funds would be available when lady luck might leave many in the smaller towns broke. Sometimes the way to make a complex problem more reliable is to add to its complexity.

Spreading the risks inherent in a smaller town financial world to larger cities does make things safer – as long as nothing big hits all the regional financial institutions as well. So the logical next protection step is to spread the risk even further by including all the nation’s financial institutions in a network of guarantees. Again, this works as long as no big, adverse event hits all financial organizations at the same time.

Believing that a financial institution that is “too big to fail” increases the risk of system-wide failure is absurd. Catastrophic system-wide risk comes from the risk of a catastrophic system-wide disaster. In such a situation all financial institutions are hit hard, regardless of their size. That risk of collapse exists regardless of the scale of the institutions and comes from the basic system of guarantees wherein institutions look to other institutions for safety. Only the strong, whether big or small, will survive. When the situation is bad enough all connected dominoes will fall, and a few big ones are much easier to support than a sea of little ones. Smallness is a liability when dealing with a systemic failure. So what can one do to prevent this failure?

The answer is the one that the Federal Reserve Bank, the United States’ “bank of last resort,” used in 2008. At that time, the Fed instantly manufactured enough money to shore up the existing guarantees among the major financial institutions. “Printing money” to back up the guarantees was a terrifying task because nobody, not even insiders, had any way of knowing exactly how extensive the complex tangle of guarantees might be or the amount of money needed to arrest the chaos. The Fed saved the day because it was able to put overwhelming monetary pressure on a few key pressure points. In a world where all financial institutions are “too small to succeed,” the institutions become an army of cats that is impossible to herd.

Most of our Canadian friends understand the importance of having key intervention pressure points ready if needed. Canada’s cornerstone financial institutions are all “too big to fail.” Many Canadians clearly see that trying to sort out the complex guarantees among thousands of falling little dominoes and doing it in an environment where billions can and do move in milliseconds is absurd. Keeping thousands of little dominoes standing makes any system too small to succeed because swift and comprehensive interventions are not possible. When key institutions are “too big to fail,” central bankers have the key pressure points needed to intervene decisively and immediately. Being able to act immediately in support of critical inter-institution financial guarantees is the only way to win a financial war. Anyone who thinks that today’s international electronic banking is not a current, continuing, and vicious financial blood sport among people and nations needs to wake up.

Yes, most Canadian policymakers get it. They see that the risk from falling dominoes is the problem and that you can hold up a few big dominoes far more easily than you can support thousands of little ones. The system of inter-institution guarantees will keep thousands of little dominoes standing when a few big dominoes are kept standing. They also seem to understand the need for dealing with facts and logic when looking at a financial system, whereas Bernie Simpleton – in the name of helping the “little guy” – approaches the problem guided only by a complexity-free and uncalibrated moral compass.

Facts and logic are what one uses to calibrate a moral compass, but don’t waste your time trying to tell that to Bernie Simpleton. Financial Simpletons live in a cause-and-effect world in which uninformed morality sees everything as violating some moral precept and not interconnecting with anything else in substantive ways. It is a world in which everything is somebody else’s fault. Bernie would no doubt tell you that he loves Canadians – just not those Canadians who think the web of life is at all complex.

Canadians seem to get it from another angle as well. In some ways, Prime Minister Justin Trudeau is cut from the same cloth as Bernie Simpleton, but with an important difference: Trudeau has a brain in his head. Bernie Simpleton wants to raise corporate income taxes sharply even though those taxes are already the highest in the First World. He thinks this will bring jobs back to the U.S. and fund his welfare plans. No matter that current taxes already have driven an obscene amount of money and jobs out of the U.S. to more welcoming places. Trudeau has used his head enough to see that Canada will be better off by lowering Canadian taxes enough to import any American businesses and jobs that U.S. Simpletons might drive away. Any such match between Bernie Simpleton and Justin Trudeau is a guaranteed win for Canada.

In a Simpleton’s world, little guys can only be hurt by big guys. Simpletons see people as living in hierarchies where the people on the bottom are at the mercy of those at the top. In this world, there is no bidirectional interdependence, just top-down exploitation. It is no surprise that navigating this Simpleton’s world requires an uncalibrated moral compass.

Now you can honestly say “Nobody told me.”

Copyright © 2016-2019 Charles E. Dial. All rights reserved.
Posted Apr 20, 2016 at 10:21. Revised Aug 14, 2019 at 08:17. –> Retrieved Dec 14, 2019 at 17:11.
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