Too Big to Fail

By Murli Dhar

This expression is commonly employed with reference to big financial institutions. It simply means that those institutions have assumed such a big size in the different countries they operate from that their failure cannot even be contemplated. Were they to fail, they would bring in their trail the failures of numerous others who are dependent on them and who are critical to the normal functioning of the entire economy.

With time, banks and other financial institutions have employed their initial dominance in the economy to grow even bigger. We have this kind of market dominance in the shape of the Mauritius Commercial Bank and the State Bank of Mauritius in our case.

More than two-thirds of the domestic banking functions in the country are vested in these two banks. This means that most of the savings of the country are lying in those banks. More importantly, they also account for the biggest shares of the domestic loan market. A lot depends on their good judgement and there are clear pointers from other parts of the world that their judgement may be seriously flawed when they go single-mindedly after profits.

Governments realized the full impact of such dominant key business structures during the international financial crisis which began in 2007. The banks did not limit themselves to their core activity. They developed instead other money-churning auxiliary financial activities such as investment banking on a huge scale.

Staggering expansion

By packaging together financial business all and sundry under one roof, they threatened to bring down an even bigger edifice of economic activity in each country of their operation in the event they were to fail. Yet, instead of their managements taking fright at their staggering expansion, the problem was transferred to the authorities, namely the governments and financial regulators.

This is why when such gargantuan financial institutions started showing the first signs of cracking when the international crisis came, western governments rushed out to re-capitalize them with several hundreds of billions of dollars of taxpayers’ money just to prevent a more catastrophic breakdown of entire swathes of the economy that were dependent on them. They were mildly referred to as systemically important financial institutions.

On Tuesday last, Chairman Ben Bernanke of the Federal Reserve of the United States (Fed) was called upon to testify in front of Congress about the Fed’s monetary and regulatory policies. In particular, members asked about how the US government could have come to caution big financial institutions against failure by dishing out huge subsidies to them.

According to a study by Bloomberg, a subsidy of no less than $83 billion has been given out to systemically important finance houses to prevent them from collapsing. The governments were sending out a signal that they would bail them out in case of difficulty, as the alternative would be to bring the entire economic edifice to destruction. The governments were thus dispensing an insurance policy for which no premium is paid by the concerned finance houses.

It was stated that those institutions had used their strength on the market to run down the smaller financial institutions and grown bigger at the expense of others. They had also caused laws and rules to be changed by their constant lobbying of lawmakers so as not to have to comply with normal prudential rules of safe market conduct. The more they dominated over the marketplace, the more legislators had obliged by doing their bidding, finally giving them life-or-death position over the rest of the market.

Market abuses

As might have been expected, the Fed Chairman skilfully shifted the debate to future concerns instead of focussing, like Congress representatives, on the market abuses resorted to by those big conglomerates so far. He stated that it was contemplated that the retail banking component of the too-big-to-fail finance houses would be cut off from their investment banking activities. That would ensure, according to him, that the segregated units would not pose a life-threatening risk to the rest of the system. We have to see whether and to what extent this will be done, making the world a safer place from those dominant players on the market.

For the present, legislations such as Glass-Steagall, the Volcker Rule and the Dodd-Frank, which could have cut down the dominant conglomerates to size, have been put in sufferance due to the enormous pressure those big financial institutions have been exerting on policy-makers against their implementation. But House Representatives would not be fooled: they asked why it was taking so much time and why shareholders were not putting up the decent amount of capital to fully assume the risks that existed already.

Mauritius would be well advised to make sure that it does not end up putting everybody at serious risk by continuing to put all its eggs in a couple of huge financial baskets. Who, of the Ministry of Finance and the Bank of Mauritius – and for that matter the Financial Services Commission since there are market-dominant non-bank e.g., insurance, actors as well – will take the first step not to expose us to business concentration risk in the financial sector?

We are being told in no uncertain terms from what has been happening in the West as to what to expect if we let certain components of the financial sector assume an increasingly too-big-to-fail importance in the economy. The two sides need to cooperate to steer clear of such an impending danger. Will they?

* Published in print edition on 1 March 2013