Too Big To Fail, Part II: Who Are The Firms?

As I mentioned in my last post, I am poring over the new proposal (.pdf) out of the House Financial Services Committee to create a new framework for financial stability. Most of that means addressing the too big to fail problem. In this post, I'll specifically analyze how the new regulatory Council will (explained in my previous post) will evaluate which firms are systemically risky.

Generally, the proposal says that the Council will be identifying financial firms that would threaten financial stability if distressed or have a nature, scope or mix of activities that pose a threat to the economy. But more specifically, here are the criteria it will be using:

- Amount and nature of assets
- Amount and nature of liabilities (including reliance on short-term funding)
- Extent and nature of off-balance sheet exposure
- Extent and nature of transactions and relationships with other financial companies
- Importance as a source of credit for households, businesses and governments
- Importance as a source of liquidity for the financial system
- Nature, scope and mix of activities
- Any other factors the Council feels like considering

These seem like the right criteria to consider to me. I especially like the specific mention of reliance on short-term funding. In a credit crunch, firms who are heavily reliant on short-term funding will fail far more easily than those who have long-term funding secured. Turning over their debt was one of the problems that did Bear Sterns and Lehman in.

I'm a little less convinced it matters how important a source of credit these firms are. There are plenty of big financial institutions out there to pick up the slack on providing credit if one or two big ones failed. Of course, I concede the point that if any such institution truly provided a remarkable market share of consumer, business and government credit, then that does matter. But I'd also argue that such a firm's dominance might better be addressed through antitrust regulation, since a firm that large might have price setting power.

The proposal also mentions that the Council will periodically revise the list of identified firms, adding or subtracting firms as the market changes. That's sensible.

One very interesting provision gives emergency identification authority to the Treasury, Fed and FDIC, with the blessing of the President. Presumably this will serve as a measure to take care of any firm whose problems put stability at risk, but the situation that arises was unforeseen. This, frankly, wouldn't differ much from what happened during the crisis, as that group of three seemed to be running most of the show.

Finally, I think this is noteworthy:

The Council and the Board may not publicly release a list of companies identified under this section.

You would want to keep this list secret so to prevent those firms from being exposed to the benefits and costs that would result from being on the list. Creditors might assume a firm's presence on the list means it's too big to fail, so a safer bet for lower funding costs. Equity investors might think a firm's returns will be lower, because of the additional cost more regulatory restraint would cause.

Of course, these firms are going to have substantially different regulatory requirements from their peers. So I find it hard to believe that just by reading annual reports and other filings, savvy investors and creditors couldn't figure out who these firms are. Still, I appreciate the attempt to keep this list nonpublic, even though I believe it will ultimately fail.