The Too Big to Fail Meme Explained

The Too Big to Fail (TBTF) meme is, if understood, a shorthand for something more than the size of the Wall Street investment banks.

TBTF is of course the idea that because banks are interconnected in our financial system, the failure of a large bank has repercussions on the rest of us. Hence, we are obliged to rescue them when they are on the brink of failing.

The three key questions that arise are: (1) what’s wrong with having to rescue a failing bank, (2) can it be avoided and (3) are there other issues here not being discussed directly?

(1) What’s wrong with having to rescue a failing bank? Those who wish to let failing banks fail without our help are in a few camps. One camp says that they don’t deserve to be rescued for poor performance and misconduct of their own doing, especially when others, more innocent and more vulnerable, e.g., homeowners, were not rescued. It smacks for good reason of favored person status among the plutocrats. (Recent revelations of the SEC turning a blind eye even on actual convictions of hedge fund investors reinforces this view as does the extraordinary lack of criminal charges in the case of the financial crisis.) Another camp – most mainstream economists are in this group – care very little about what is fair and more about efficiency and the role of incentives. These folks worry about so-called ‘moral hazard’ which is the idea that if a firm knows in advance that you will rescue it if the risks it takes on blow up in a downside scenario, that firm will take on too much risk and impose too much risk on the rest of us. (In its financial decision making, they are now discounting the downside of highly volatile investments, thus raising the ranking of those that impose the greatest risks on the enterprise and on the rest of us.) In other words, we not only rescue banks for failing normally, but we distort their incentives so they are more likely to fail. Still another camp is comprised of “free-market” ideologues (the subset who are not charlatans merely promoting the power and profit of business, but the group who actually believe in markets) who do not want the government bailing out anyone; they want firms to be unfettered to both succeed and fail. The bailouts make them unhappy for obvious reasons.

(2) Can it be avoided? The simpler TBTF critics want us to believe that by making banks smaller, they will be small enough to fail. This may not be right for a few reasons. (1) Small banks are still interconnected, so small bank failures will still lead to small charges to the rest of us – the problem that they are not being forced to fully subsume their own costs and mistakes goes on; (2) Break large banks into many small banks and if they fail the sum of those small charges may still add up to a lot of problems for the rest of us, demanding a rescue of some sort, anyway; (3) the chaotic/ catastrophic aspect of financial systems means that a butterfly flapping his wings can cause a tsunami – so even small bank failures that are still connected can cause outsized harm. (If you unplug a supercomputer you have tampered with a tiny part of it but you have caused a major problem.) So interconnectedness counts as well as size and it may be too complex for us to forecast and manage.

(3) The other issues not being discussed were highlighted in The Big Short where we learn that the investment banks are problematic for reasons apart from their size and interconnectedness. We see firsthand that the big investment banks (especially Goldman Sachs) have displaced the market altogether – fixing prices when it would cost them profit until they can manipulate buyers into taking on toxic assets and only then moving prices in line with market pressures. THIS MARKET DISPLACEMENT is (1) illegal, loosely, but should be punishable by extreme measures; (2) a product of power and opacity more than size; (3) a product of incompetent regulation, although it may not even be possible to regulate this sort of behavior. THIS FEATURE IS ARGUABLY MORE IMPORTANT THAN SIZE. All arguments in favor of markets, all arguments in favor of finance capitalism, all arguments that say that we have to take the bad (gross inequality) to get the good (supposed efficiencies) go out the window if THERE IS NO MARKET, but instead there is a profit-seeking vulture at the heart of the system fixing prices for their own profit.

So this problem cuts at the heart of finance capitalism. If you solve it, the system we have may be justified (with other fixes). If you don't solve it, all the formal arguments for finance capitalism go out the window and you may as well try socialism or something else.

In this last, both political extremes, socialists and social democrats at one end, and Tea Partiers on the other, can agree. Mainstream and radical economists can agree. We need a financial system in which banks are not so interconnected that their mistakes make us sick – but that is hard to fix. We need a financial system in which banks are not so big that their failure will cause crises – but making them small is not a complete solution. And, arguably most important, we need a financial system in which markets function honestly and players are never so powerful, opaque, or “made” (like a mobster) that they can manipulate prices of billions of dollars without vigilant regulation and extreme prosecution.