Too Big to Fail, or Just Too Big?

I just read a discussion paper by Dr James B Thompson of the Research Department of the Federal Reserve Bank of Cleveland (2009, “On Systemically Important Financial Institutions and Progressive Systemic Mitigation”), in which he proposes various criteria for identifying and supervising financial institutions that are “systemically important.” According to Dr Thompson:

Delineating the factors that might make a financial institution systemically important is the first step towards managing the risk arising from it. Understanding why a firm might be systemically important is necessary to establish measures that reduce the number of such firms and to develop procedures for resolving the insolvency of systemically important firms at the lowest total cost (including the long-run cost) to the economy.

Dr Thompson further argues that disclosing the identity of firms that may eventually be designated “systemically important” would require “constructive ambiguity” in order to ensure the market is not mislead into believing certain firms retain special dispensations in the form of government guarantees.

The choice of disclosure regime would seem to be between transparency (publication of the list of firms in each category) and some version of constructive ambiguity, where selected information is released… In the context of central banking and financial markets, the term [constructive ambiguity] refers to a policy of using ambiguous statements to signal intent while retaining policy flexibility. In the context of the federal financial safety net, many have argued for a policy of constructive ambiguity to limit expansion of the federal financial safety net. The notion here is that if market participants are uncertain whether their claim on a financial institution will be guaranteed, they will exert more risk discipline on the firm. In this context, constructive ambiguity is a regulatory tactic for limiting the extent to which de facto government guarantees are extended to the liabilities of the firms that regulators consider systemically important.

After considering Dr Thompson’s ideas, I am flabbergasted with doubts. My first is with regard to the dogma implied by “systemically important” (i.e., “too big to fail”). What does “systemically important” mean? What makes a company “systemically important?” Dr Thompson sidesteps the “too big to fail” proposition by coining the alternative phraseology, “systemically important,” which is equally lambaste with normative relativism. The entire concept of “systemically important” lacks content validity, both in rhetoric and substance. To say a firm is “systemically important” is just another way of designating the firm as “too big to fail.”

My second doubt centers on the need for “constructive ambiguity” in disclosing the identity of firms that are designated as “systemically important.” The suggestion that “constructive ambiguity” will somehow protect the markets is preposterous. What the marketplace needs today is greater transparency, not less. The very notion of “constructive ambiguity” is laced with deceit. Ambiguity can only further harm the stature and creditability of our financial markets, especially given the recent collapse of public confidence in the face of the ongoing economic crisis.

My final comment is to offer a new suggestion for dealing with firms that are either “systemically important” or “too big to fail,” and that is we treat such firms as simply too big to keep around. Firms that are so large as to become “systemically important” or “too big to fail” should be broken up into smaller companies, thus advancing the competitive spirit of the marketplace, while ensuring that no firm becomes so large as to be able to threaten the financial stability of our nation as a consequence of their misfortunes.

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