Is 'too big to fail' a failed idea?

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Banks stress test results have leaked out and -- not surprisingly -- Bank of America (BAC) and Citigroup (C) have been told to raise billions in new capital. Since the banks probably can't get that capital, they are making a stink -- rebutting the results of the stress test. And as I posted, the banks may have a point because the stress tests are deeply flawed.

But this news raises a broader question: Why not just let failed companies fail? In my mind, the concept of free markets is that if you succeed, you get a reward and if you fail, you suffer. But in the current economic contraction, the government mechanisms put in place after the Great Depression are not sufficient to dampen the suffering that failed management teams impose on innocent customers or employees.

What am I talking about? In the case of the banks, it's the FDIC which is supposed to help failed banks fail gracefully while preserving customer's deposits. But the FDIC can't do its job -- it only had $19 billion in its reserve fund at the end of 2008 and projected a need for $65 billion to handle failed banks through 2013. It could not handle the failure of Citi, for example which has $831 billion in deposits.

And in the case of General Motors (GM) and Chrysler, it's the Pension Benefit Guarantee Corporation (PBGC) whose job is to secure the pensions of people who work for companies that file for bankruptcy. But the PBGC also lacks sufficient capital -- it already operates at an $11 billion deficit so it's in no position to handle the $20 billion deficit in GM's pension fund as of last November.

The 'too big to fail' doctrine exists because the FDIC, PBGC, and other insurers of last resort lack sufficient reserves to protect depositors and workers, respectively, in dealing with the failure of big banks like Citi or companies with enormous pension funds, like GM. In short, it's a classic problem of an insurer that under-estimates potential losses and thus does not have sufficient reserves.

Too big to fail is a deeply flawed doctrine because it is keeping alive companies that have failed in the marketplace creating big societal opportunity costs -- the resources being used to prop up failed companies could be better applied to building new companies that could satisfy the demand that these zombie companies are not meeting.

Moreover, that too big to fail idea converts free markets into Republican Socialism -- the idea that if you get big enough, then the bottom 99 percent of citizens will pay the top one percent big bonuses during up markets and cover the top one percents' failures in down markets. This kind of incentive system is what led to the current financial disaster.

So what do we do? In the short-run we need to create a process for allowing big firms to fail in a way that does not cause the entire global economic system to collapse. But the people who created the problems should suffer the loss rather than shifting the blame onto the rest of society.

In the long run we need to replace too big to fail with a different approach. How so? We could use antitrust laws to keep firms from getting to the scale where they're too big to fail. Or we could let big firms stay big and just require them to find their own private forms of insurance to cover the extra amount of risk that they impose on the rest of society.

Regardless of the solution, it's clear to me that too big to fail is a failed doctrine that should be euthanized promptly.

Peter Cohan is president of Peter S. Cohan & Associates. He also teaches management at Babson College. His eighth book is You Can't Order Change: Lessons from Jim McNerney's Turnaround at Boeing. He owns Citi shares and has no financial interest in the other securities mentioned.

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