Eugene Fama: “Too Big to Fail” Perverts Activities and Incentives

In our continuing financial debate, one of the central myths – put about by big banks and also not seriously disputed by the administration – is that reigning in “too big to fail” banks is in some sense an “anti-market” approach.

Speaking on CNBC at the end last week, Gene Fama – probably one of the most pro-market economists left standing – pointed out that this view is nonsense. (The clip is here, and also on Greg Mankiw’s blog; TBTF is the focus from about the 5:50 minute mark.)

Having banks that are Too Big To Fail, according to Fama, is “perverting activities and incentives” in financial markets – giving big financial firms,

“a license to increase risk; where the taxpayers will bear the downside and firms will bear the upside.”

Fama is not backing down from any of his previous strong pro-market views – as explained by David Cassidy in the New Yorker recently (the full article on the Chicago school is also good, but requires a subscription) – and we can argue about his views on the functioning of financial markets or capitalism more broadly.  When everyone is opportunistic and the “rules of the game” themselves are up for grabs – for example through lobbying based on existing and expected future super-profits (e.g., from being allowed to exercise any form of monopoly) – then bizarre and bad things can happen.

But, in any case, Fama is completely correct that,

 “[Too Big To Fail] is not capitalism.  Capitalism says – you perform poorly, you fail.”

He is also correct that “complicated regulation may be a nice idea in principle but in practice it never works”.  Regulators get captured by the people they are supposed to be regulating (as now illustrated in the oil and gas industry); this is “not unusual; it happens all the time”.

Fama has obviously considered just letting big banks fail (“I would have been for that all along”), but he recognizes that this cannot work in our political realities – governments will step in and make bail for banks when there is serious trouble.  And, as Senator Ted Kaufman pointed out in his exchange with Senator Mitch McConnell, allowing the collapse of huge banks is a recipe for turning crisis into catastrophe.

Fama argues “the only solution is to raise capital requirements of these firms dramatically,” maybe up to 40-50 percent, which is an idea we have also advanced.  It’s an interesting question whether this by itself would take the failure of mega-banks completely off the table – that would probably depend on the extent to which they were allowed to game the system, for example with risk taken through derivative positions against which they hold too little capital.

Still, Fama is thinking along exactly the right lines – and this is further confirmation that the consensus on big banks is shifting

If implemented properly, capital requirements of the kind he proposes would essentially force the largest six or so banks today to become much smaller.  Given that capital requirements are set by regulators, who claim to be pro-market, they should take careful note of Fama’s views – and look for ways to implement a tough version of this approach.

Originally published at The Baseline Scenario and reproduced here with the author’s permission.