Too Big to Fail?

“Too big to fail” seems to be a point of discussion again. The theory is that allowing failure of the nation’s largest financial institutions would cause catastrophic disruption of credit markets and the nation’s economy. This theory was not put into practice in the United States until the creation of Federal Deposit Insurance and then not for another thirty years. Since the 1980’s and the bailout of Continental Illinois Bank and Trust setting the precedent that the nation’s largest financial institutions are deemed too big to fail. The argument is made that previous bailouts and the standing “too big to fail” policy allowed large institutions to act irresponsibly and cause the worst financial crisis since the Great Depression.

A current vocal critic of the “too big to fail” policy is Thomas M. Hoenig, president of the Kansas City Federal Reserve Bank and the longest serving Federal Open Market Committee member. Hoenig is quoted as having accused the government of “regulatory malpractice” in modifying regulations without dealing with, what he believes is a core issue, too big to fail.

Certainly inadequate caution by large financial institutions contributed to the recent near financial collapse in the United States and throughout the world. If we can believe what we read in the press, measures are being taken to improve regulations and oversight of the nation’s monetary policy and its large financial institutions.

If the “too big to fail” issue is dealt with then what does that do to the value of long term investments in those, previously protected, large financial institutions? On the one hand a better run bank is probably a better investment than a poorly run bank in danger of needing a bailout. On the other hand much of the money made by large financial institutions came from derivatives and other leveraged investments. A large financial institution, knowing that there is no potential bailout in case of financial disaster, may do business more conservatively. A conservative large financial institution will be a safer one and a more conservative large financial institution will generate less of a profit and have a lower stock price as well.

Bank stocks have traditionally been conservative investments. If the “too big to fail” issue is adequately addressed they will become more conservative. That is, large banks will be very safe investments at a lower price and lower returns. Large brokerage houses will still see their values go up and down with trading volume but internal financial practices would probably also become more conservative if there is never a bailout possibility.

“Too big to fail” begets recklessness. Recklessness can result in short term profits and adversely affect other institutions. As the reckless large financial institution makes more profits other large financial institutions are forced to mimic their actions or risk being bought out in hostile takeovers as they see their stock prices drop. Thus, it does not take a financial collapse for investors to pay the price of the recklessness engendered by “too big to fail.” If “too big to fail” is addressed, the long term investor will need to look at his or her portfolio to see which large financial institutions may need to clean up their act and see their stock price readjust to a more realistic level.