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Bernanke on ‘too big to fail’ and incentives

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Yesterday Federal Reserve Chairman Ben Bernanke gave a speech to the Council of Foreign Relations. I heard a few soundbytes on Radio NZ National on my way home last night and was particularly interested in his comments on the concept of ‘too big to fail’.

Bernanke identifies that in a crisis, authorities have strong incentives to prevent the failure of large, interconnected firms, due to the negative externalities that arise from their failure. Such firms might be considered ‘too big to fail’.

However, Bernanke also identifies the undesirable effects that stem from the belief of market participants that a particular firm is considered too big to fail:

  • Market discipline is reduced and excessive risk-taking by the firm is encouraged.
  • There is an artificial incentive for firms to grow, in order to be perceived as too big to fail.
  • It creates an unlevel playing field with smaller firms, which may not be regarded as having implicit government support.
  • And finally, bailouts are extremely costly to taxpayers. See Citigroup, AIG, GM, Freddy Mac, the list goes on.

In the perfect world, no firm would consider themselves too big to fail and hence the undesirable effects stated above would be avoided. However, the reality is that firms have been behaving as if they were too big to fail. Unfortunately we are now in a global economic situation where to not act would lead to potentially far greater problems. That is not to say I believe every big firm in trouble deserves a bailout though!

Importantly, Bernanke correctly identifies that the current crisis does offer an opportunity to try and shape incentives so that the too big to fail mentality can be avoided in the future. To me this is the critical thing. Greater scrutiny of such organisations has the potential to make great savings further down the line. As Bernanke says, “Any firm whose failure would pose a systemic risk must receive especially close supervisory oversight of its risk-taking, risk management, and financial condition, and be held to high capital and liquidity standards.”

If such an outcome arises, hopefully we will never have to hear the term too big to fail again.