Too Big to Save

"There aren't enough lifeboats.  Someone is going to die. So you might as well enjoy the champagne and caviar." - Jamie Dimon, CEO of JP Morgan Chase to his staff the night before Lehman filed for bankruptcy

In the argument over banks being too big to fail it seems that there are a few key missing pieces of information.  First off is that one of the large banks will fail again at some point in the future regardless of what regulations are put into place.  I am certainly not saying that it will happen tomorrow but it will happen, there is no question about this.  Why am I so sure?  First history has a tendency to repeat itself and second bankers by their very nature are intent on maximizing profits.  In order to maximize profits risk has to be taken and leverage is often used.  Normal banking leverage is already high when compared to the rest of society (10 to 1; even your riskiest stock broker will only give you 2 to 1) and this level pails into insignificance when taken up to the derivative trades made off balance sheet.  In fact when you look off balance sheet you find trades with leverage in the magnitudes of 1,000s of times the global GDP!  One small shake of this stick and everything collapses but that is for a different blog post.  The point to the argument is that one or many major too big to fail banks will at some point in time collapse.

The second problem is that as global trade becomes more and more interrelated and borders are crossed at will by large corporations, they will require banks that can manage the complexities associated with each countries regulators.  If you were the CEO or Treasurer of Apple for example would you want to have a new bank account at a new bank in each country where the company's products are sold or would you rather go to JP Morgan and have them open a branch next to your satellite head quarters in each country, consolidate all the cash balances in one statement and provide you instant access to monitor the situation in any branch around the globe?  Of course you would choose the second option meaning that big banks are not only here to stay I expect them to get bigger.

So it really is not a question of creating regulations to make banks smaller but to me trying to ensure that should a large bank fail that it does not impact the lives of ordinary citizens.  A simple solution is to regulate banks so that their growth is restricted based on their chosen types of operations.  So for example let's say that bank one provides our Apple Treasurer with everything that he needs and remains a plain vanilla bank that operates in a multitude of countries.  One could argue that as the bank is not involved in trading or underwriting or derivative transactions that the risk of the bank failing is limited.  In this case holding a 10% reserve requirement seems reasonable and should protect investors and the globe against the fallout should the bank fail.  The bank is still huge and could be considered too big to fail but the impact should it fail should be minimal.

On the opposite side of the equation bank two provides not only the normal banking functions but behind the scenes is anything but a a bank (in its true form) but is rather a banking hedge fund where the majority of its results are derived from trading and other gambling style investments.  This bank obviously has a higher level of risk associated with its survival and should therefore not only hold significantly higher reserves but should also have to show regulators how the pipes that connect them to the rest of the banking community will continue to operate should they vaporize.  Assuming that the pipes will continue to operate without them then the systemic risk is relieved.  Now this is really easy to put into print and virtually impossible to do right now but in reality if the penalties were such that if the bank cannot show a way to allow the rest of the banking world to function without them then it would be a relatively easy job to raise the level of reserves required by the bank until such time as they can show this ability.  One thing I do know is that if the tables are turned, the bank will work out a solution.

So instead of regulators running around in a desperate attempt to reign in something they will never keep abreast of and forcing a size constraint on an operation that is required to keep the global economy functioning and growing; I believe that it is time to turn the tables and create a simple solution of too big to save.  Any bank that falls under this heading (and they are not hard to spot) has a simple choice, raise the reserve requirements to unheard of levels or off load those operations.  These banks would then be left to fail next time around.  The funny thing is with the safety net removed I would not be surprised to see banks change their colors pretty quickly.  As an example, if a banks operations make it risky and the face value of its derivative portfolio are larger than 20% of global GDP then it becomes too big to save.  At this point the bank must either tone it down or post 30% reserves with the IMF or the Federal Reserve.  Once it can control its greed then it can go back to business as normal.  The current discussions on too big to fail are failing themselves, wasting tax payer money and will not result in a solution to the problem for the simple reason that, as has happened throughout history, the regulated problems of the past will be superseded in the blink of an eye as the banks will have morphed into something new and unregulated.

It is time to move on from too big to fail and realize that regulations should be designed around too big to save!