Too-Big-To-Fail Considered Harmful

On 15th September 2008, the Lehman Brothers investment bank filed for bankruptcy protection. Their shares fell 90% that day, and the assets of the company were later scattered between Barclays and Nomura and some other smaller entities, according to Wikipedia’s article on the company. It had grown from its founding in 1850 to assets of US$639b, making it the biggest bankruptcy in US history.

That a company so big was allowed to fail shocked the financial services industry, and the global financial crisis shifted up a notch. Within a week, the two largest US investment banks (Goldman Sachs and Morgan Stanley) had turned themselves into banks with greater access to Federal Reserve funding. From what I can tell, no company that large was allowed to fail again during the global financial crisis.

There was talk that many such companies were “too big to fail”: that the repercussions to the economy and society if they failed would be so dire that governments would step in to save them. This is a troubling notion, and there is clear moral hazard where the sole reason to stop a company failing is that it is “too big”.

The principle of entrepreneurs taking on risky ventues, and being rewarded if they succeed, is a basic one in a capitalist society. However, if there is no chance of failure when a venture gains a certain size, then there is an incentive to create unsustainable growth until that size is reached, when rewards will be obtained at no risk. Or, to put it another way, the government of the day chooses to take all the risk for companies with the riskiest behaviour. This is clearly not something in either the economy’s or society’s interest.

Alternatively, if a large company was discovered to be following illegal business practices, under the rule of “too big to fail”, a regulator would not step in and take action against the company, because it would put the company at risk of failing. This isn’t a good idea either.

So, if propping up a big, failing company is a bad notion, what are the alternatives? Well, the obvious one is to let them fail. Obviously there are also the options of either making them smaller (e.g. split them up) or stop them getting big in the first place.

That said, big companies may be propped up if there are reasons for it other than their size. Letting all of Iceland’s major banks fail hasn’t done it any favours. Still, in Australia, if CBA, NAB, WBC or ANZ failed, I’m not sure what we’d do.