Saving capitalism.

John Kay is one of the most lucid, accessible economic thinkers out there: pragmatic, insightful, skeptical and perhaps most importantly not prone to hyperbole. If you don’t already read his weekly FT columns (also archived and published here), I highly recommend them. (Perhaps one day I’ll get the opportunity to meet him, and be able to convince him to join our advisory board.) His column yesterday, “Why ‘too big too fail’ is too much for us to take” was particularly articulate and on target:

Commercial success and democratic election are the only sources of legitimate authority in a society that no longer relies on spiritual leadership nor respects hereditary titles. An organisation exempt from either of these disciplines represents an unaccountable concentration of power. As we have today at Citigroup, Barclays and Deutsche Bank.

If “too big to fail” is incompatible with democracy, it also destroys the dynamism that is the central achievement of the market economy. In principle, there is no reason why disruptive innovations and radically new business models should not come from large, established, dominant companies. In practice, the bureaucratic culture of these organisations is such that this rarely happens. Revolutions in business generally come from new entrants. That is why so many of today’s market leaders – Microsoft and Google, Vodafone and Easyjet – are companies that did not exist a generation ago. These companies could not have succeeded if governments had been committed to the continued leadership of IBM and AOL, AT&T and British Airways.

If there is one single learning we as democratic capitalist societies need to take away and apply in earnest from the Crash of ’08 it is to put in place mechanisms, policies, regulations, norms – whatever is needed, to ensure that no private or public commercial entity is ‘too big to fail.’ The externalities on society are too important (and the mis-pricing of these is probably the largest contributing factor to the excessive rents that accrue to such entities in times of stability.) The wonderful thing is that with the technology and economic infrastructure of the 21st century, it is entirely possible to implement a market-based pricing of intangible externalities if – and sadly this is far from a given – sensible, good faith laws and rules are put in place. The markets in pollution permits is an obvious example, although as has been seen in the carbon markets, all too often we see the entrenched power of incumbents forcing a distortion of the rules to dilute their effectiveness (think free allocation of CO2 permits vs. auctioning.)

(One of) the analogs in finance you could imagine would be a market in Central Bank liquidity rights: the right for a bank to borrow say 12mo funds from the Central Bank at a set rate or margin. Banks would have to hedge the committed lines of credit they extend with these liquidity rights. Designed correctly (tricky no doubt but doable), these could trade in a free market, with the Central Bank auctioning off and participating in secondary market operations to manage their supply and demand. With these you could actually price liquidity (perhaps not perfectly but still) and if they had existed, I suspect that banks would have been much more cautious before writing trillions of dollars worth of committed back-stop facilities to structured finance vehicles (SIVs, etc.) and corporates at derisory pricing.

For those of you that aren’t bankers – for years these kind of facilities were written even for weak credits with tiny commitment fees, most between 5-15 basis points (ie 0.05-0.15%.) They were never ‘expected’ to be drawn, and so were often treated as free money when in effect they were just out-of-the-money options sold without regard to the tail risk. Another ‘picking up nickels in front of a steamroller’ strategy that failed catastrophically. Of course everyone knew that these facilities were underpriced, and for most banks (but some of the dumb money smaller banks) they were notionally acknowledged as loss leaders to win other business. This in itself is not a problem per se. The problem arose because these ‘loss leaders’ actually made revenues and accounting profits (of course while storing up enormous contingent risks but these were invisible and seen as so unlikely as to be irrelevant, just like for super-senior CDO tranches) and so it was only too easy to keep selling more and more of them. A loss leader than makes you money: what’s not to like about that?

John Kay finishes his argument with a succinct recommendation:

“Too big to fail” – whether the claimant is a bank or an auto company – is not a status we can live with. It is both better politics and better economics to deal with the problem by facilitating failure than by subsidising it.

There has been much noise (on both sides of the Atlantic) on the appropriate role of government with respect to giving a financial boost to new ventures and entrepreneurs, especially given the vast sums that have been targeted towards failed giants. This is a debate for another time, but I suspect the single most effective thing governments could do to help entrepreneurship, innovation and economic renewal sustainably, over the long term and with the least risk of unintended consequences, would be to heed Mr. Kay’s call and ensure that henceforth no company in any sector is ever again too big to fail.

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