Banks 'Too Big to Fail'? Wrong

For the past year and a half, we have been focused on the contagion infecting global financial markets, a contagion started by consumers' inability to control spending, to live within their means. It is well documented that this contagion was amplified and spread when securities backed by mortgage obligations that certain consumers failed to meet started to fall in value, and for this reason, investors started keeping money on the sidelines, and banks stopped lending to one another.

This clogging of credit has been deemed a good reason for the federal government to intervene in the financial markets. The driving premise offered is that investment banks such as Bear Stearns and commercial banks such as Bank of America (BAC), Citigroup (C), and JPMorgan Chase (JPM) are "too big to fail." I was always under the impression that capitalism was about taking risks, including the possibility of all-out failure. I thought capitalism was about reaping rewards from taking risks. Instead, the government chooses to treat market participants like consumers who continually expect that some safety net be provided for every transaction. We should allow big banks to fail because "market stability requires it."

There are two dynamics here. One is our loss of appetite for risk. When it comes to the American attitude toward risk-taking, we have lost our swagger. We have regulated risk away to the point that we are now scared to let a Bank of America or a Citigroup wind down and dissolve.

No General Market Collapse

Let us not forget that there are thousands of community, regional, and national banks that could come in and buy up the deposits and performing loans of a Citigroup should it fail. The federal government erred in believing that the failure of one bank amounts to market failure. The market never failed and, I argue, is not failing. Were the financial markets really ever in any danger of collapsing? I do not think so. According to the Federal Reserve, the amount of consumer credit outstanding increased by 2% between fourth quarter 2007 and fourth quarter 2008. Granted, outstanding consumer credit fell to $2,562.3 billion in fourth quarter 2008 from $2,582.1 billion in third quarter 2008, but look at what was happening to the demand side of the market.

In short, fewer people were dropping by the money store to buy cash from the banks. According to the Labor Dept., unemployment increased from 6.5% in October 2008 to 7.2% in December 2008. If you are concerned about the future of your job because more and more of your neighbors are collecting unemployment, the last thing you plan to do is borrow money. This doesn't mean that the market is collapsing.

It is unfortunate that the Obama Administration fails to see that the risk of failure leads to efficient choices. Imagine what the behavior of banks would be if there were no TARP funds to access? They would either dissolve, thereby removing an inefficient player from the market, or seek to produce synergy by merging with another going concern. All this without costing the taxpayer a dime.

Ignorance in Congress

The other dynamic here is the lack of knowledge on the part of members of Congress who are responsible for oversight of the industry. Their ignorance scares me. If you are going to pursue a path of market inefficiency and approve access to government funds by banks, shouldn't you appreciate what a rational firm would do with fresh capital? The classic example occurred last week when the chief executives of eight major banks appeared before the House Financial Services Committee and were subjected to a berating by the committee members. The beat-down was expected. What was surprising was the committee members' failure to exhibit, at least during those hearings, adequate knowledge regarding corporate governance and the economics of a market.

Why, given the increase in unemployment and foreclosures, would you seriously expect these firms to lend more money to consumers who are not creditworthy? Also, if the financial markets are not functioning because certain banks are undercapitalized, why would you not expect the recipients to stabilize the market by acquiring other firms? It is this lack of knowledge that allows these very politicians to be hoodwinked into an argument that a bank is too big to fail.

The Obama Administration and Congress can put stability back into the markets by allowing and requiring that market participants pursue risk.

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