Overcoming the “Too Big To Fail” Phenomenon

Treasury Secretary Timothy F. Geithner has given the broad outlines of the Obama Administration’s proposal for reform of the nation’s financial regulatory system. The Treasury Secretary’s announcement will raise the intensity and sharpen the focus of the debate about the scope and specifics of reform.

Among the important questions that must be addressed in the course of this debate is the “too big to fail” phenomenon, which has so infected the current crisis. A principal reform objective should be to minimize the number of systemically significant institutions that, in the future, would fall into this category.

What does “too big to fail” mean? Over the past year, this term has meant that certain institutions are perceived as so big that policymakers are afraid to see what happens were the institution allowed to fail. The difference in the federal response to investment firms Bear Sterns (saved from collapse) and Lehman Brothers (not saved) illustrates that this judgment is hardly a precise one.

American International Group, Inc. (AIG) is the poster child for the “too big to fail” phenomenon. In September 2008, on the verge of the company’s collapse, the Federal Reserve determined that AIG was too big to fail because of the potential national and international impact of such a failure. AIG’s collapse could have had devastating financial consequences to not only AIG’s stockholders and employees, but to the millions of average Americans who hold insurance policies through one of the many (approximately 72) AIG wholly owned insurance subsidiaries. It is estimated that in the United States AIG has issued 375 million insurance policies with face values of approximately $19 trillion.

In the financial sector, changes in the legal regulatory structure actually encouraged the outsized growth of institutions. This “too big to fail” phenomenon did not just happen, nor is it entirely the result of economic forces over which we lack meaningful control. Instead, Congress authorized its occurrence. The good news is that can revoke that authorization. PARA As the culmination of a bipartisan effort to deregulate the financial services industry, Congress passed the Gramm-Leach-Bliley (GLB) Act in 1999. The purpose of GLB was to allow affiliation among banks, securities firms, and insurance companies. This gave financial companies the flexibility to set up new companies through a holding company or financial subsidiary. GLB repealed the Glass-Steagall Act of 1933, the depression era law that prohibited a bank holding company from owning other financial companies.

On November 12, 1999, the day that President Clinton signed GLB, former Senator Phil Gramm, one of the bill’s sponsors (and now an executive for international financial giant UBS) said that the protections of Glass-Steagall were outmoded because in the 1930s, it was believed that stability and growth came from government overriding the function of free markets. “We have learned that freedom and competition are the answers,” Senator Gramm said. “We have learned that we promote economic growth and we promote stability by having competition and freedom.”

This wave of the future set the stage for the colossal corporate structures that blended traditional insurance business with banking and other higher-risk financial services with devastating consequences.

When failure is not an option

There is a considerable cost to allowing institutions to reach a scale where failure becomes “unthinkable” or “unallowable.” That cost goes well beyond the billions of future taxpayers’ dollars we are now using to prop up these institutions.

In the pre-bailout era, the operating assumption for most business enterprises was that failed businesses went out of business. The market extracted a steep cost for firm-jeopardizing bad judgments. That cost was bankruptcy. The theory of our system was that the market rewarded success and punished failure. This system, at least in theory, operated within a set of incentives that rewarded both individuals and firms for success. This incentive system also was supposed to discourage individuals and firms from taking such excessive risks as to jeopardize the viability of the enterprise.

This entire theory now sounds literally quaint. As we have seen, the road to federal subsidies in the present crisis is open -- if not entirely a smooth ride -- to only the truly large firms that have failed on a massive scale. While bailouts of these failures may be necessary to save the entire system from collapsing, they occur at the expense of the discipline that is at the core of our economic system. One cannot both believe in the theory of our economic system - we reward success and punish failure because that incentivizes success and disincentivizes failure - and deny that eroding this discipline is a substantial cost to saving failed firms from their failures.

Size is not the only issue. We must look carefully at the blurring of the line between insurance products and investment vehicles. Insurance is not just another financial service. The goal of insurance is to manage and pool risk, while investment is intended to reward those who take risk. The current crisis is an opportunity to readjust the regulatory system to recognize that the purchase of insurance and investment in securities are two quite distinct and fundamentally different things. The choices and risks involved with each must be plain to consumers. Consequently, Secretary Geithner and Congress should examine carefully the role that the passage of the Gramm Leach Bliley Act has had on confusing the difference between the two and ultimately putting consumers at risk.

Our point is not to criticize the decisions that have been made to bailout certain firms. Our point is that going forward we as a nation should seek to avoid being compelled to save failed firms by a fear of what such failures would mean.

We now know beyond doubt the enormous risks of having firms of a size, scale, and complexity and  that the functioning of the economy depends on their continued existence. When firms are so embedded into the economic infrastructure that global prosperity may depend upon their existence, these firms need not fear failure because, as we have seen, the public treasury will end up having to own their failures. That kind of economic extortion cannot be squared with any reasonable notion of a regulated market economy.

In the future, the only way to avoid this trap is to discourage the creation of firms on a scale beyond a size safe to collapse. In the global economic world in which we live and in which we as a nation must compete, there will inevitably be such firms. But they should be few. We should not adopt regulatory policies that encourage their creation and we should repeal existing regulatory policies that paved the way for our present predicament.

The views expressed in this article are solely those of Commissioners Tyler and Stakem Horning.

Author bios

Ralph S. Tyler is Maryland Insurance Commissioner. Prior to his appointment, Tyler served as the state’s Chief Legal Counsel and Baltimore City Solicitor. He has more than 30 years of experience in the practice of civil litigation in both trial and appellate courts. Tyler holds degrees from the University of Illinois (BA), Case Western Reserve University (J.D.), and Harvard University (LL.M.).

Karen Stakem Hornig is Maryland’s Associate Deputy Insurance Commissioner. Hornig was educated at the College of Notre Dame of Maryland (BA) and the University of Maryland School of Law (J.D.).