Economics, Financial Services, Pethokoukis

Another way ‘too big to fail’ skews market forces

Credit: Benjamin Dumas (CC BY-NC-SA 2.0)

Credit: Benjamin Dumas (CC BY-NC-SA 2.0)

If you have a chance, please have a look at my National Review column for an update on some recent progress in ending government distortions in the US financial sector. One angle on the issue that I fail to mention is how TBTF actually prevents market forces from restructuring Too Big To Manage megabanks. The Financial Times fills in that gap:

A closer look tells us why they cannot yet succeed in forcing big finance to spin off units to be better run, nimbler, more competitive and more effective in the manner of the big 1980s and 1990s industrial takeovers and conglomerate restructurings. Consider the incentives for restructuring too-big-to-fail financial firms. Suppose active shareholders were to decide that, say, a large bank would be better run if its biggest units were spun off into smaller ones. An active investor – in the mould of Carl Icahn or T. Boone Pickens – might eye up the companies and naively agitate for a break-up. “A company this big and complex can’t be managed well, no matter how good the chief executive is,” they might say. “It is worth twice as much broken up.”

But once they began working through the maths of a restructuring, they would find that shareholder values would not shift upwards in the way they might have predicted.

If the banking conglomerates were carved up into their constituent parts, the individual units would have a much higher cost of capital. Today, when financial conglomerates such as JPMorgan borrow to finance themselves, their creditors know the government will probably pay them back in full even if the bank fails because the systemic economic costs of their failing to do so is too large. Creditors therefore charge the conglomerate less. So the firm’s cost of capital becomes cheaper.

3 thoughts on “Another way ‘too big to fail’ skews market forces

  1. So much misinformation there, hard to know where to begin.

    Banks are spinning off activities all the time. Citi has been restructuring for several years, spinning off all sorts of lines of business. In many cases spinning of lines of business RAISES capital. In some cases it reduces drain on capital. In some cases it raises costs, some cases lowers costs, just like other firms. Other banks of all sizes have been doing the same.

    ABN Amro was a large European conglomerate that was indeed broken up to maximize value. It was bought by a team of financial firms that each wanted different pieces. True, timing was bad, as all of this happened on the verge of the financial meltdown, and some of the acquisitions worked better in the recession than did others (RBS clearly paid too much for its piece). But even in those conditions, it is the example of one of the world’s largest firms that was dismantled by market players.

    We have seen similar restructurings in the U.S. Two of the largest U.S. banks today are actually the result of smaller, less-well known but more vibrant banks that took over the better-known but more struggling firms. Today’s Bank of America is actually NationsBank, that bought BofA and took on its name. Today’s Wells Fargo is actually Norwest Bank, same story, acquiring Wells and taking on its name. We need a regulatory system that continues to allow churning at the top, growth in the middle, and new entrants at the bottom.

    Recent studies by S&P, and other data referred to by Fed Chairman Bernanke, indicate that in fact there is growing market recognition that debt investors in large banks are subject to losses in the event of failure, and banks are paying a premium for their debt as a result. But they are not paying the same premium. Investors are weighing–and banks are paying–according to market perceptions of the likelihood of losses to bond holders.

  2. This would be funny if it weren’t scary as h*ll. The shadow banking system (Wall St et al) is LARGER than it was in 2008 when its excesses came close to reducing global finance to the barter system. (For one, the Treasury was obliged to explicitly guarantee money market mutual funds to forestall a run on them.)
    So we have unregulated shadow banks that “can create systemic risks” and “amplify market reactions when market liquidity is scarce,” according to the Financial Stability Board. What’s the point of devolving regulated banks to neighborhood institutions?
    Well, if megabanks didn’t have advantages because of their implicit govt guarantees, then Wall St could bring on the next crash that much faster. Three words of advice on Mr. P’s work. Follow the money.

  3. If a couple banks can bring down the entire economy the size of the US economy at what? Fifteen trillion dollars in total GDP,something is out of whack.Put your investments in your local banking institutions it is better for your local economy anyways.

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