The Good And Bad Of Banks Too Big To Fail Getting Bigger...

from the not-all-bad,-but... dept

Ever since the whole financial crisis began, and the concept of "too big to fail" became a common phrase, I've been wondering why the US gov't didn't set up a simple provision in any bailout procedure: if you are too big to fail, and because of that need a gov't bailout, then a part of that bailout means you need to become small enough to fail. I think it's a perfectly reasonable suggestion that has been pretty much totally ignored.

So, when news came out that the biggest banks, the ones deemed "too big to fail," are now getting even bigger, you might think that I'd view that as a bad sign. And... partly, I do. But not for the reasons you might expect. The issue of "too big to fail" isn't the bottom line size of the bank, it was about how interconnected it was in the rest of the economy, and how any ripple effects of a failure would damage (significantly) other parts of the economy. But, since the government has done pretty much next to nothing to actually deal with that sort of systematic risk (and, no, putting in place a "systematic risk" manager, as we keep hearing, isn't going to fix the problem), it should come as no surprise that these banks still have such risks.

But, the fact that, by themselves, these banks are growing isn't a bad sign. Given what the government has done, it's actually a good sign. You should be a lot more upset if, after the government gave these banks so much money, they went out and lost it all. Instead, many of them have at least put it to good use (and some have returned money to the government at decent interest rates -- though, the amount returned still is a blip compared to the amount at risk).

The real issue isn't the size of the banks, but how interconnected they are. But little to nothing has been done to take on that problem -- which is a bad thing. However, given that, it's at least a decent sign that these banks we've given so much money to are actually doing better these days.

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Too Big To Fail Isn't The Problem... It's The Hidden Risk That's The Problem

from the as-if-that's-possible dept

Duncan Watts has a thought provoking writeup in the Boston Globe talking about the problems of systematic risk, and why no one could successfully see exactly how the various dominoes would fall, leading to our current (and still ongoing) economic financial crisis. Basically, his argument is that the system has become too intertwined and complex, such that no one can really manage the risk. This is hardly a new idea. Watts' suggestion (which, again, is not necessarily new, and has been discussed by many, including Treasury Secretary Tim Geithner) is that perhaps we need a "systematic risk manager" within the government, whose job (like anti-trust folks) is to look at various companies and determine if they're too big to fail -- and then see how to change things such that they're no longer too big to fail.

It's a nice idea... in theory. In practice, it's a lot harder. The very reason systematic risk is such a problem is that it's so hard to even imagine the scenarios taking place. The idea that Lehman Bros. failing would have so much impact elsewhere is simply beyond the scope of what most people could have even imagined -- and that would almost certainly include any "systematic risk manager." While I agree that it's a problem that we end up with companies that are "too big to fail," I tend to think, in the long run, it's futile to try to predict ahead of time who's really "too big to fail," but that such an issue should only come up in the event of a gov't bailout. Thus, if you need to take gov't money to stay alive because you are deemed "too big to fail," then it should be required that as a part of the terms of the deal, you need to work out a plan that makes you small enough to fail.

Otherwise, you end up in a situation where companies who are successful get penalized for it. The only time "too big to fail" is a problem is when such a company fails. We shouldn't necessarily be penalizing a company that's too big to fail if it's not going to fail.

Separately, Watts notes that this idea of trying to prevent "too big to fail" is a way of avoiding systematic risk. I'd argue he has the equation a bit twisted. Too big to fail isn't the problem. It's the hidden risk that leads a company that is "too big to fail" to fail that's the problem. The answer to that is not breaking up successful companies -- it's increasing transparency into actual risk. That means increasing openness and data sharing, rather than the status quo of quarterly reports with the real details hidden and buried beneath complexities, combined with Wall Street putting together packages whose sole purpose is designed to hide the actual risk. Make the real data transparent (and real-time) and let anyone access and mess around with the data, and you get a much more accurate view of the risk, and you avoid situations where "healthy" investments suddenly turn sour.

Watts has the right idea that systematic risk is a problem, but the wrong solution. Companies that are too big to fail failing is a symptom of a lack of transparency over the actual risk. The answer isn't to stop companies from getting so big. It's to provide more transparency into the actual risk.

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Blaming Failure On The System Actually Does Have Some Benefits...

from the before-we-trash-everything-here... dept

A bunch of folks have sent in Daniel Gross' excellent review of the World Economic Forum in Davos last week, where he bemoans the fact that no one is willing to step up and take the blame (or even find people who should shoulder the blame) for the economic collapse we're all living through. He has a great line near the beginning:

Success is the work of Great Men and Great Women, while failure can be pinned on the system.

Indeed, in reading the article, I definitely agreed, and sometimes I find it troubling that we credit success stories to individuals who were often much more lucky than anyone cares to imagine, and when failure occurs, no one's willing to admit that they had any part in it. However, in thinking about it some more, I'm less and less sure that this is a bad thing. In many ways, it's actually an important part of creating future success stories.

If we went around blaming individuals for every failure, it creates tremendous incentives not to take on the necessary risk to create those next breakthroughs. The difference between success and failure is often such a fine line it's difficult to see. In almost every success story you hear of one or two minor things that could have brought the whole thing crashing down if things had gone differently. But in celebrating the "heroes" associated with success, we create incentives for others to experiment and take necessary risks. In not punishing the individuals behind the failures too harshly by calling them out for "blame" we don't create incentives to avoid those necessary risks. That's a good thing.

That isn't to say that we shouldn't look at what happened and why it went wrong, but it's right to look at the systems that went wrong and how to fix them, rather than calling out people to tar and feather. That's counter-productive and only makes it that much more difficult to encourage the next generation of entrepreneurs to take the necessary risks to create economic growth.

Of course, there is one additional point that needs to be made here. Despite what I said above, there is a significant problem when we interpret that initial sentence to mean we should then socialize the loss -- and pin the effects of it on taxpayers, which seems to be exactly what this country has done all too often.

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Venture Capitalists: Buying High, Selling Low

from the not-the-greatest-strategy dept

We were a bit confused following the last dot com boom when various venture capitalist went into hiding when it came to new investments. Suddenly they said that since the market was bad, they wouldn't make any more investments. That didn't make much sense. After all, VCs are supposed to be investing for the long-haul -- usually in the range of five to seven (plus) years. What the market is doing today is rather meaningless. In fact, investing heavily during a downturn is often a good strategy. There are fewer competitors investing, you can invest at lower valuations (buy low!) and your investment has more time to mature against less competition. Yet, it looks like many venture capitalists are taking that same strategy again, with many deciding that it's time to hold off on doing new investments until the wider market appears to improve. The worst stat in the bunch is that VCs are particularly shying away from seed stage deals -- which are the cheapest deals that need the most time to mature anyway. That's effectively a strategy that says says they'll wait until it's more expensive to buy again. Venture capital is called risk capital for a reason. If VCs don't want to take risks, they shouldn't be in the business. About the only reason I can see why it might make sense for VCs to hold off investing is if they really think their own investors will default on capital calls -- meaning they really don't have as much money to invest as they thought they had. But, if that's the case, VCs are in bigger trouble anyway.

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Bruce Schneier Has An Open Wi-Fi Network

from the share-and-share-alike dept

Bruce Schneier, one of the sharpest people in the computer security world, has a great piece about why he leaves his home wireless network open for anyone to use. When I wrote something similar a couple of years ago, I caught a lot of flack from people who said that I was opening myself up to security risks, either from people downloading child pornography with my connection or from people hacking into my home computers and stealing my data. But as Schneier points out, neither of these risks is unique to your home wireless network. Like Schneier, I've got several restaurants and coffee shops within walking distance of my apartment that offer free wi-fi access. While it's not impossible that somebody would park their car out in front of my street and use my Internet connection to do something illegal, it seems more likely that they'd do so over a cup of coffee in one of the nearby coffee shops, where they wouldn't evoke suspicion. Moreover, I have a laptop and I visit coffee shops and other locations with open wi-fi connections all the time. If my laptop has security vulnerabilities, I should be a lot more worried about getting cracked on those networks (which make it easy to target a bunch of people at once) than that I'll have the bad luck of living next to a cracker. I need to keep my laptop properly locked down in any event. Once I've done that, an open wi-fi network is a fairly minor risk. Finally, Schneier closes by pointing out that security is a trade-off. If perfect security is your standard, you shouldn't connect to the Internet at all, because there's always a risk of a security breach. Given that we're willing to accept some level of risk if we have a good reason, the question we should be asking is about the relative risks of different activities. The risk of leaving your wireless network open isn't zero, but it's probably small.

Now, I should point out that all of this assumes that you're a reasonably technically savvy individual with an understanding of basic security concepts: that you know how to update your operating system on a regular basis and that you've set the administrative password on your access point to a non-default value. If you're a complete networking neophyte (not that many of those probably read Techdirt), you should probably get some advice from someone more technically savvy about good Internet security practices. Actually, you should do that whether or not you choose to open your wireless network. But on the list of potential network security threats, an open wi-fi network is probably pretty low on the list.

Timothy Lee is an expert at the Insight Community. To get insight and analysis from Timothy Lee and other experts on challenges your company faces, click here.

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