What does “too big to fail” mean?
The Alternative Banking meeting yesterday was really good, and interesting. During the discussion someone raised the point that when we describe a bank as “too big to fail,” we almost always measure that in terms of their assets under management, or the percent of deposits they have, or their net or gross exposures. In other words, we measure the size of the individual institution.
However, what’s just as important in terms of being “too big” is the extent to which a given bank is too interconnected, meaning they are in deals with so many other counterparties that if they go under, they would set off a cascade of contractual defaults which would cause chaos in the entire system. In fact Lehman was like this, too interconnected to fail. It’s funny but I’m pretty sure Lehman wasn’t too big to fail under many of the current definitions.
Although this question of counterparty risk is brought up consistently, it’s never adequately addressed in terms of risk; we are still more or less asking people to measure the volatility of their PnL, and we typically don’t force them to expose their counterparty exposure in stress tests and whatnot.
What if we addressed this directly? How could we regulate the interconnectedness of a given institution? What would be the metric in the first place and what limits could we set? How could we set up a regulator to convincingly check that institutions are sticking to their interconnectedness quotas?
I’ll keep thinking about this, they are not easy questions. But I think they are important ones, because they get to the heart of the current problems more than most.
A further question brought up yesterday was, how do we know when the entire financial system is too big? I guess we don’t need any fancy metrics to say that for now we just know.