Monday, August 10, 2009

Too Big To Fail Or Too Big To Survive

A thoughtful analysis and article by John Carney on Business Insider, "Why Do Banks Grow Too Big To Fail?"
So why are there big banks? The primary reason for any firm to grow is to avoid some of the transaction costs of using the markets. The transactions costs avoided by centralizing costs in one firm include the difficulty of discovery the relevant prices, as well as the costs of brokering deals and raising capital from outsiders.

But this avoidance of the market is also a disadvantage, as avoiding market prices subtracts from a bankers knowledge and makes efficient economic calculation difficult.

This is actually the central economic dynamics of a capitalist economy. Prices are important to economic calculation but they involve transaction costs. Eliminating transaction costs from dealing with external price markets is the leading explanation for why firms exist at all, and why they grow. But this also has a cost of making prices less transparent, and economic calculation more difficult. The size of any firm is probably dependent on how these things balance out: transactions costs and calculational chaos costs.
Read the entire article here.

I would add to Carney's article that the failure to have accurate pricing in the big institutions misled the firms on the riskiness of their endeavors, postponed the recognition, internally and on accounting statements, of the decline in the value of their investments in securitized assets and contributed to the credit tightening and financial crisis.

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