A new psychosis is striking Wall Street giants that want to avoid aggressive regulatory oversight

600 too big to fail REUTERS Shannon Stapleton.jpg

Something important was discovered during the financial crisis: some firms are so large and so interconnected that their collapse would set off a chain reaction that would bring down the entire economy. The "too big to fail" problem was born. But since then it has evolved. With new financial regulation imposed on the industry, a psychosis has arisen, which we might call "systemiphobia" (the fear of being deemed systemically relevant and regulated accordingly). Symptoms of the disorder include firms proclaiming they aren't too big to fail, desperately trying to avoid proving that they can, and secretly hoping that they would be rescued.

"Who? Little Old Me, Too Big to Fail? No Way!"

On Sunday, Eric Dash and Julie Creswell from the New York Times reported on a really amusing phenomenon that's becoming very common. The heads of large financial firms are heading down to Washington to proclaim their insignificance:

Hedge fund managers, for example, normally pride themselves on being Masters of the Universe. But armed with PowerPoint presentations and financial studies, representatives from some of Wall Street's most powerful funds, including D.E. Shaw and Company, Elliott Management and Caxton Associates, met with Federal Reserve staff members earlier this year to make one point: We're too small to matter.

Why would a firm want to be seen as unimportant? Because last summer's financial regulation bill gave the federal government sweeping new power to regulate the firms that it decides pose a systemic risk to the economy. If a firm is seen as not posing such a risk, then it will not face associated additional regulatory burdens, like higher capital requirements in some cases. So it's fine -- even desirable -- if the market sees you as a major force in the financial industry, as long as you remain under Washington's radar.

"Of Course I Can Fail, I Just Don't Wan to Explain How That Would Work"

Another important provision of the financial regulation bill provided the government with the power to wind down large failing firms. The idea is to avoid a bankruptcy like we saw with Lehman, which destabilizes the economy. Instead, the Federal Deposit Insurance Corporation will attempt to wind down even the largest of firms quickly, cleanly, and efficiently, to avoid contagion.

Initially, some big financial firms supported the idea. For example, JPMorgan's CEO Jamie Dimon wrote an op-ed in 2009 in support of the idea. But the bank and others now have some concern about the implementation of the new resolution authority and the "living wills" that it requires. Those are plans that each firm would submit to the government explaining how their failure would work. In a letter to regulators, the lobbyists who work on behalf of these firms write:

There are potentially severe business-model and competitiveness consequences to any financial firm if the Federal Reserve and the FDIC were to jointly determine that the company's Section 165(d) resolution plan is "not credible," including further increases in capital and liquidity requirements, leverage limits, activities limits and even forced sales . . . supervisors should not create a system that manages for failure rather than for success.

Yet is there anything wrong with hoping for the best, but planning for the worst? The firms' complaint here is a little bit hard to swallow. The letter urges regulators to help each firm develop a plan that would evolve. That seems perfectly reasonable -- so reasonable that it's difficult to imagine that regulators weren't planning on doing this already. If they found an initial plan failing to meet their expectations, would they really just impose punishments or seek to determine whether or not its defects could be easily corrected?

Instead, these firms may just be looking for flexibility to allow them to avoid tough consequences if it is not possible to develop a plan that would provide for their swift, tidy resolution. Indeed, it's hard to imagine how some of these behemoths could be would down without causing economic catastrophe -- no matter how sure regulators are of their ability to control the situation.

"Oops, Guess I Am Too Big To Fail After All -- Now Where's My Bailout?"

And when firm do fail that regulators can't neat sweep up, it's pretty clear which ones will be in the best situation -- those that were actually too big to fail, but were not regulated accordingly. In a future U.S. financial sector, there will be three sorts of firms: those that aren't too big to fail, those that regulators believe are too big to fail and face strict oversight, and those that are too big to fail but weren't believed to be.

Despite their similarities, those latter two types of firms face different consequences upon collapse. If a regulated systemically relevant firm has developed a reasonable failure plan, then the government will likely attempt to wind it down upon default. It will have faced substantial regulation, but will ultimately fail.

The secretly systemically relevant firm has the best of both worlds, however. It won't face that harsh regulation, but will have to be rescued. If there's no plan in place to resolve it neatly and cleanly, then the government will have no choice but to bail out the firm to avoid dire economic consequences.

It's not difficult to figure out which situation here is preferable from a firm's standpoint. There's no mystery as to why firms want to avoid being classified as systemically risky. No firm wants to face higher regulatory costs. But no matter their classification according to regulators, if they turn out, in fact, to be too big to fail, then it's quite likely that they'll be rescued.

So as systemiphobia sets in, expect to see more big firms trying to convince regulators that they don't matter. Unfortunately, determining which firms are too big to fail isn't an easy task for regulators. If regulators possessed such clear foresight, then perhaps the whole mess of 2008 would have been avoided.

Image Credit: REUTERS/Shannon Stapleton

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