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.

Too Bad Financial Regulatory Agencies Do Not Know Coase's Work

New financial industry regulations are very likely in response to the current recession and financial industry crisis. The restructuring of the various government agencies that oversee the financial industry is still uncertain. For example, see The Washington Post story, "Goals Shift For Reform Of Financial Regulation."

Turf wars among the various agencies and the several Congressional agency oversight committees are the major political obstacles to a rational reformulation of the oversight and regulation of the US financial services industry. Effective changes to financial industry regulations also require an understanding of the causes of the perceived current financial industry crisis, both from a product supply side, i.e. the over production of risky, housing related investment products, and the demand side, i.e., the over investment and lack of diversification in housing related investments.

None of the current explanations is very satisfying as they all rely on a suicidal tendency of firms to self-destruct or irrationality to the point of absurd stupidity. Nor does employee compensation structure offer any explanatory help since only one side of the transaction was volume compensated, usually the seller and not the buyer (investor) of the product.

However, if the political architects of the proposed new regulatory structure and regulations familiarized themselves with the works of Ronald Coase, they would realize that the extent of industry changes that will occur at the end of their hard work and analysis is limited. The changes to the regulatory structure and regulations are important only to the extent that they change the transaction, including search, costs of the firms they supervise and regulate.

Based on Coase's Theorem and Coase's work on the Nature of the Firm, the regulated firms, independent of the starting point, will voluntarily transfer rights, obligations and functions among themselves based on costs and efficiencies.

Just as mortgage originations that fed securitized products shifted to loosely, state regulated mortgage bankers from banks, functions will shift among the various financial firms based on costs and efficiencies. The shifts will be independent of the number of agencies supervising the industry and new regulations.

Most likely, individual firm regulatory and transaction costs will remain relatively stable pre and post Congressional changes to the regulation and supervision of financial industry firms.

No matter how the new rules modify the starting point of the rights and responsibilities of financial firms, the firms will reallocate among themselves based on costs and efficiencies.

All the major financial firms that ran into trouble are already highly regulated, supervised and transparent to the regulators. There is little likelihood of any of the proposed changes resulting in any fundamental shift in the total industry's product offering or product demand.

Congressional and Executive staff will work very hard for little change when one looks at the entire industry's functions, product offerings, demand and investments before and after their many sleepless nights.

Also see my previous post on regulation, Regulations Relocate Risk Taking.