4 ms·

I don't understand the whole "too big to fail" idea. They say that the collapse of a large institution would have a domino effect through the rest of the bankin

by jey 18y ago

I don't understand the whole "too big to fail" idea. They say that the collapse of a large institution would have a domino effect through the rest of the banking world, but how does it ever get that bad to begin with? If a particular institution is getting too big, shouldn't the other players want to hedge against its failure to protect themselves against the low-probability but high-cost situation in which a really big bank fails? Is this a situation where the market would behave like that in the ideal case (with perfect information, instantaneous communication, unbounded computation, etc) but we end up with "too big to fail" banks due to some sort of inefficiencies that occur in practice? Or is this situation due to government meddling (bailouts, guarantees, etc)? Or are these swings just due to humans acting emotionally/irrationally (e.g. in response to scare mongering news stories)? This is just a total guess, but to me it seems like it gets this bad partly because of a feedback cycle between inefficiencies of real-world markets and government meddling. The players in the real world markets don't have perfect information and instantaneous communication, so they end up not balancing their potential payoffs against the risks. The government (or central bank, whatever) steps in to rescue the system when the situation gets bad by propping up failing banks. Sounds good so far, but the problem is that this effectively functions like a zero-cost insurance policy and insulates the banks from some of the true risk of their investments. This encourages the banks to take riskier investments, since they get part of the risk paid for for free. Now you've got a positive feedback loop: banks take riskier investments due to gov't guarantee, gov't steps in when the investment goes bad, banks gain confidence in gov't bailout and make more even worse investments, rinse & repeat. It also seems like the governmental "insurance policy" encourages the kind of interdependency where one bank's failure can bring down other banks. It's more likely that the banks can collect on the insurance policy if many of them go down at once, but if only one bank is in trouble it's more likely that the government will just allow that one bank to fail. (I'm not proposing a conspiracy theory; I'm just saying that this "insurance" shifts the banks' costs/benefits towards mutual dependence and reduces the attractiveness of pursuing diverse/unconventional strategies.) OK, that's my half baked hypothesis -- what's the real explanation?

breck 18y ago
It could be that banks are unique in that a failure at one could cause consumers throughout the economy to irrationally panic, which could cause lead to a feedback cycle where a drop in confidence leads to a drop in economic activity leads to a drop in confidence etc.. In this case then due purely to chance(because even if a bank took adequate risk measures, they could still fail due to a freak event) the economy could spin into a recession without this "government insurance policy". It could be that all the top dogs on Wall Street and at the Fed are buddy-buddy, and don't want anything terrible to happen to each other, so they watch each other's backs. (Similar to how foreign rulers sometimes allow their deposed enemies to go into "exile", to hopefully win some good karma should they themselves ever become deposed). It's probably not either of these. I don't know. I don't think anybody does.
mattmaroon 18y ago
I'll try to find an economics-focused social news site and get that figured out for ya.
gaius 18y ago
It's like saying the OS is too important to crash.
- Zev 18y ago
  If the OS is powering something like a nuclear reactor, it better not crash or do something unexpected.
  - gaius 18y ago
    If a problem is identified in a truly critical system, then people will deploy whatever means are necessary to fix it. Doesn't necessarily mean they were wrong to choose it in the first place (but it might).
ardit33 18y ago
I agree. In my country there is no real equivalent of Fanie Mae/Fredie Mac, so in order to get a mortgage you must have proven income, stable job, and at least %30 down payment. It makes it harder to buy a house, but deliquinces are low, and prices are not heated up. If banks had to bear the risk of issuing the mortgages, you would see lending standards tightenning up overnight, and most of the risky borrowrers wont be able to get any mortgages, which actually is a good thing. In the article it says how Fanie Mae started this huge campain so the congress would loosen up the credit requirement in the name of "house affordability" for the poor etc... when it was actually self-centered policy, by the top executives so Fanie Mae could keep its profits rising, and their bonuses flowing. Of course, this would backfire at some point, but who cares, they made their money in the bank, who cares on what happens 10 years down the road, the goverment will bail them out, right...? I really hope the goverment doesn't, and just let them go down. It would be fun. Actually houses will end up being affordable for those people that live honestly within their means, have good credit, stable jobs, and a good amount of savings, while the irresponsible wont be able to even get a mortagage anymore, (or one with reasonable rates).
- davidw 18y ago
  > It makes it harder to buy a house, but deliquinces are low, and prices are not heated up. Prices rose quote a bit in Italy and especially Spain, despite having similar conditions to those you describe.
  - Xichekolas 18y ago
    The price boom in Spain was mostly due to British and German expats buying up coastal condos and villas. Many of the Spaniards I know in Andalucia (a southern coastal province) complain that housing prices are outlandishly high, to the point of unaffordability. Because of this (and the traditionally higher unemployment rate in the south), it's often customary for kids to live with their parents into their 30s before they can afford a house (and a family) of their own. A comparable house in Ronda, Spain to those in my native Kansas is roughly twice as expensive, but to a Londoner accustomed to things costing four times that (eight times Kansas prices), Spanish houses look like a great deal.
curiousgeorge 18y ago
>> If a particular institution is getting too big, shouldn't the other >> players want to hedge against its failure to protect themselves >> against the low-probability but high-cost situation in which a >> really big bank fails? Evidence seems to suggest the market does not work this way. Sometimes, it appears not to work at all.
- byrneseyeview 18y ago
  In many cases, the problem is that if it did fail, lots of other institutions would almost certainly be wiped out. Imagine that you open a flood insurance office right next to a levee in New Orleans. You could price things rationally, but if there's a flood you're dead anyway, so why not price your insurance low and live it up in the meantime?
- pmorici 18y ago
  In this case as the author explains the reason they were able to grow so big is because of government involvement which through implicit and explicit measures made the risk appear artificially low.
helveticaman 18y ago
The best explanation I've come up with is people have been playing Russian roulette with mortgages. It's mostly a zero-sum game.* During the boom, a lot of people made money by firing empty rounds at their temples, and got out of the game. But some people fired when there was a bullet in the barrel, losing an amount similar to that gained by the luckier players. The problems come when the gamblers weren't even using their own money to begin with. The winning gamblers got their commissions, management fees, and incentive fees, while the losers don't lose much that is their own. Then, the costs get socialized. The Fed guarantees Bear Stearns for some fucked-up reason, making all taxpayers liable for the gambler's losses. With the Fannie Mae, this happened in reverse; first the gambler was isolated from getting a bullet in her brain, then the gambler proceeded to play Russian roulette. *However, this game is not zero sum when it comes to markets. First, houses are rather illiquid, and second, meltdowns create unemployment and other inefficiencies. There's a reason nobody really plays Russian roulette in real life.
s_baar 18y ago
As a rule, when water flows uphill, the government is intervening. What free market do you know of in which the failure of a firm isn't a boon to their competitors?

by jey 18y ago

breck 18y ago

It could be that banks are unique in that a failure at one could cause consumers throughout the economy to irrationally panic, which could cause lead to a feedback cycle where a drop in confidence leads to a drop in economic activity leads to a drop in confidence etc.. In this case then due purely to chance(because even if a bank took adequate risk measures, they could still fail due to a freak event) the economy could spin into a recession without this "government insurance policy". It could be that all the top dogs on Wall Street and at the Fed are buddy-buddy, and don't want anything terrible to happen to each other, so they watch each other's backs. (Similar to how foreign rulers sometimes allow their deposed enemies to go into "exile", to hopefully win some good karma should they themselves ever become deposed). It's probably not either of these. I don't know. I don't think anybody does.

mattmaroon 18y ago

I'll try to find an economics-focused social news site and get that figured out for ya.

gaius 18y ago

It's like saying the OS is too important to crash.

Zev 18y ago
If the OS is powering something like a nuclear reactor, it better not crash or do something unexpected.
- gaius 18y ago
  If a problem is identified in a truly critical system, then people will deploy whatever means are necessary to fix it. Doesn't necessarily mean they were wrong to choose it in the first place (but it might).

ardit33 18y ago

I agree. In my country there is no real equivalent of Fanie Mae/Fredie Mac, so in order to get a mortgage you must have proven income, stable job, and at least %30 down payment. It makes it harder to buy a house, but deliquinces are low, and prices are not heated up. If banks had to bear the risk of issuing the mortgages, you would see lending standards tightenning up overnight, and most of the risky borrowrers wont be able to get any mortgages, which actually is a good thing. In the article it says how Fanie Mae started this huge campain so the congress would loosen up the credit requirement in the name of "house affordability" for the poor etc... when it was actually self-centered policy, by the top executives so Fanie Mae could keep its profits rising, and their bonuses flowing. Of course, this would backfire at some point, but who cares, they made their money in the bank, who cares on what happens 10 years down the road, the goverment will bail them out, right...? I really hope the goverment doesn't, and just let them go down. It would be fun. Actually houses will end up being affordable for those people that live honestly within their means, have good credit, stable jobs, and a good amount of savings, while the irresponsible wont be able to even get a mortagage anymore, (or one with reasonable rates).

davidw 18y ago
> It makes it harder to buy a house, but deliquinces are low, and prices are not heated up. Prices rose quote a bit in Italy and especially Spain, despite having similar conditions to those you describe.
- Xichekolas 18y ago
  The price boom in Spain was mostly due to British and German expats buying up coastal condos and villas. Many of the Spaniards I know in Andalucia (a southern coastal province) complain that housing prices are outlandishly high, to the point of unaffordability. Because of this (and the traditionally higher unemployment rate in the south), it's often customary for kids to live with their parents into their 30s before they can afford a house (and a family) of their own. A comparable house in Ronda, Spain to those in my native Kansas is roughly twice as expensive, but to a Londoner accustomed to things costing four times that (eight times Kansas prices), Spanish houses look like a great deal.

curiousgeorge 18y ago

>> If a particular institution is getting too big, shouldn't the other >> players want to hedge against its failure to protect themselves >> against the low-probability but high-cost situation in which a >> really big bank fails? Evidence seems to suggest the market does not work this way. Sometimes, it appears not to work at all.

byrneseyeview 18y ago
In many cases, the problem is that if it did fail, lots of other institutions would almost certainly be wiped out. Imagine that you open a flood insurance office right next to a levee in New Orleans. You could price things rationally, but if there's a flood you're dead anyway, so why not price your insurance low and live it up in the meantime?
pmorici 18y ago
In this case as the author explains the reason they were able to grow so big is because of government involvement which through implicit and explicit measures made the risk appear artificially low.

helveticaman 18y ago

The best explanation I've come up with is people have been playing Russian roulette with mortgages. It's mostly a zero-sum game.* During the boom, a lot of people made money by firing empty rounds at their temples, and got out of the game. But some people fired when there was a bullet in the barrel, losing an amount similar to that gained by the luckier players. The problems come when the gamblers weren't even using their own money to begin with. The winning gamblers got their commissions, management fees, and incentive fees, while the losers don't lose much that is their own. Then, the costs get socialized. The Fed guarantees Bear Stearns for some fucked-up reason, making all taxpayers liable for the gambler's losses. With the Fannie Mae, this happened in reverse; first the gambler was isolated from getting a bullet in her brain, then the gambler proceeded to play Russian roulette. *However, this game is not zero sum when it comes to markets. First, houses are rather illiquid, and second, meltdowns create unemployment and other inefficiencies. There's a reason nobody really plays Russian roulette in real life.

s_baar 18y ago

As a rule, when water flows uphill, the government is intervening. What free market do you know of in which the failure of a firm isn't a boon to their competitors?