The myth of “systemic failure” in banking
5 June 2009
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Government and Institutions
Government and Institutions
Lifestyle Economics
15 November 2024
The threat of “systemic failure” has been used to justify recent government interventions in the financial sector. Essentially it is a “market-failure” type of argument – that bank failures and their repercussions impose huge “external costs” on the wider economy. Failure in the market, a perfectly normal, healthy experience, has therefore not been allowed by the authorities during the credit crisis.
There is a strong argument that the importance given to the threat “systemic failure” by policymakers owes more to interest group politics than economic fundamentals.
Indeed, this very dangerous fear has been put about by the banks themselves to justify almost any bailout by governments of the financial system. In particular it has been used by the investment banks to address the risk of their weaker counterparties failing, like AIG, who the more “successful” banks rely on to pay up their trading and numerous other losses, and thus pay the trading “gains” and other “revenues” apparently won by the investment banks.
In reality, the “good” investment banks should not have been trading with these weak players as they could not really pay their debts, i.e. they were far less creditworthy than they appeared. In their defence, the “good” investment banks knew that most of the “weaker” players were in some way or other implicitly guaranteed by governments and, disastrously for the taxpayer, these “good” investment banks have been proven right, so far. The investment banks and their lobbying machines have so frightened the politicians and the public with fear of “systemic risk” that they are now able to carry on the game regardless of the recent experiences.
At an event I attended, a very senior banker at one of the largest US investment banks actually bragged about how they were too big to fail given their “crucial” position in forex, interest rate and credit derivatives markets. It was a very ugly moment, but one that brought home to me how important it is to challenge these banks and those that fall for their propaganda in government, the financial media and academia. I don’t think Timothy Geithner is a bad guy – he is a highly competent administrator – but just sadly mistaken and actively misled by the investment bankers who surround him.
We have to free ourselves from fear of failure and free ourselves from the scaremongering by banks and the financial markets generally, one of the biggest and most successful special interest groups of modern times.
There is a strong argument that the importance given to the threat “systemic failure” by policymakers owes more to interest group politics than economic fundamentals.
Indeed, this very dangerous fear has been put about by the banks themselves to justify almost any bailout by governments of the financial system. In particular it has been used by the investment banks to address the risk of their weaker counterparties failing, like AIG, who the more “successful” banks rely on to pay up their trading and numerous other losses, and thus pay the trading “gains” and other “revenues” apparently won by the investment banks.
In reality, the “good” investment banks should not have been trading with these weak players as they could not really pay their debts, i.e. they were far less creditworthy than they appeared. In their defence, the “good” investment banks knew that most of the “weaker” players were in some way or other implicitly guaranteed by governments and, disastrously for the taxpayer, these “good” investment banks have been proven right, so far. The investment banks and their lobbying machines have so frightened the politicians and the public with fear of “systemic risk” that they are now able to carry on the game regardless of the recent experiences.
At an event I attended, a very senior banker at one of the largest US investment banks actually bragged about how they were too big to fail given their “crucial” position in forex, interest rate and credit derivatives markets. It was a very ugly moment, but one that brought home to me how important it is to challenge these banks and those that fall for their propaganda in government, the financial media and academia. I don’t think Timothy Geithner is a bad guy – he is a highly competent administrator – but just sadly mistaken and actively misled by the investment bankers who surround him.
We have to free ourselves from fear of failure and free ourselves from the scaremongering by banks and the financial markets generally, one of the biggest and most successful special interest groups of modern times.
12 thoughts on “The myth of “systemic failure” in banking”
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Even if there is the possibility of system-wide failure as a result of the failure of one bank, it raises the issue of whether the system itself can internalise the externality. Within the market, even if (say) one bank can bring down ten others when it fails, this may not matter as long as the interests of the one are aligned with the interests of the ten (in other words it is in the first bank’s interest not to fail). The too-big-to-fail mentality ensures that the interests of the one are DEFINITELY not aligned with the interests of the many. The bank can take bigger and bigger risks on a “heads I win, tails you lose” basis.
Even if there is the possibility of system-wide failure as a result of the failure of one bank, it raises the issue of whether the system itself can internalise the externality. Within the market, even if (say) one bank can bring down ten others when it fails, this may not matter as long as the interests of the one are aligned with the interests of the ten (in other words it is in the first bank’s interest not to fail). The too-big-to-fail mentality ensures that the interests of the one are DEFINITELY not aligned with the interests of the many. The bank can take bigger and bigger risks on a “heads I win, tails you lose” basis.
I’m interested you say “systemic failure” is a false pretext for Government intervention.
I do agree. It cannot have been a systemic failure which surely is something egregious, unanticipated by the usual controls; &/or, something which spreads throughout the whole system.
This is neither. We always knew failure must be contained: this is why the FSA should have enforced Basel rules on risk funding; why we used to have a Glass Steagall Act. Banks must fund their risk. If they fail, they must not pull down other institutions like a row of falling dominos.
Government bailout made this systemic. After all, losses have risen since, & every man jack of us now funds this madness.
I’m interested you say “systemic failure” is a false pretext for Government intervention.
I do agree. It cannot have been a systemic failure which surely is something egregious, unanticipated by the usual controls; &/or, something which spreads throughout the whole system.
This is neither. We always knew failure must be contained: this is why the FSA should have enforced Basel rules on risk funding; why we used to have a Glass Steagall Act. Banks must fund their risk. If they fail, they must not pull down other institutions like a row of falling dominos.
Government bailout made this systemic. After all, losses have risen since, & every man jack of us now funds this madness.
Agreed. If the government were prepared to call their bluff, we would realise that banks are not too big to fail, not now, not ever.
Agreed. If the government were prepared to call their bluff, we would realise that banks are not too big to fail, not now, not ever.
You may be right, I am not sure though. I have contacted my friend – accountant in NYC who was saying that some banks in the US donot need bailout measures, i.e. the funds inflow from the Federal Government. Chase Manhattan, Citibank – they are ok, both are among largest US banks. Everyone is saying at the same time that US banks (hinting on all of them) are in trouble. It’s not really so. Is it over-reaction? I assume, that any measures to be taken when saving banks shall take thourough approach on a bank-by-bank, sector-by sector based approach.
You may be right, I am not sure though. I have contacted my friend – accountant in NYC who was saying that some banks in the US donot need bailout measures, i.e. the funds inflow from the Federal Government. Chase Manhattan, Citibank – they are ok, both are among largest US banks. Everyone is saying at the same time that US banks (hinting on all of them) are in trouble. It’s not really so. Is it over-reaction? I assume, that any measures to be taken when saving banks shall take thourough approach on a bank-by-bank, sector-by sector based approach.
The other point how risky are the measures globally. It was as near as 1,5 bln of USD poured by the states to bailout banks andhuge mega-entities around the globe. Total assets accumulated in the funded pension schemes is about 10-12 trln USD; plus 14-15 trln USD. Under rate of 2% interest (growth) the 1,5 trln will recover in 2 years, and under 5% (say, under steady markets growth, with signs being in place now) it will take slighly higher than a year from now. Not to worry as you say, of letting the banks to fall.
But it would mean that tens or hundreds of thousands would loose jobs. It is quite differing from just not liking the banks. Social unrest, instability etc.-are they worth it?
The other point how risky are the measures globally. It was as near as 1,5 bln of USD poured by the states to bailout banks andhuge mega-entities around the globe. Total assets accumulated in the funded pension schemes is about 10-12 trln USD; plus 14-15 trln USD. Under rate of 2% interest (growth) the 1,5 trln will recover in 2 years, and under 5% (say, under steady markets growth, with signs being in place now) it will take slighly higher than a year from now. Not to worry as you say, of letting the banks to fall.
But it would mean that tens or hundreds of thousands would loose jobs. It is quite differing from just not liking the banks. Social unrest, instability etc.-are they worth it?
“14-15 bln USD” are the assets on stocks and bonds markets
“14-15 bln USD” are the assets on stocks and bonds markets