congress watch

(to be renamed when i think of something)

Stiglitz: The Too-big-to-fail Institutions Have Succeeded in Managing Their Risk

April 21st, 2009 by selise

Just starting now, JEC hearing: Too Big to Fail or Too Big to Save? Examining the Systemic Threats of Large Financial Institutions (live webcast at the link)


  • Joseph Stiglitz, Nobel Prize recipient, 2001; University Professor, Columbia University; former chairman, Council of Economic Advisers
  • Simon Johnson, Ronald A. Kurtz Professor of Entrepreneurship, MIT’s Sloan School of Management; Senior Fellow, Peterson Institute; former Economic Counselor, International Monetary Fund. cofounder of blog The Baseline Scenario
  • Thomas M. Hoenig, President, Federal Reserve Bank of Kansas City

UPDATED with audio archive:

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(note: The Congressmembers’ voices are louder than the witnesses)

From Stiglitz’s prepared statement (pdf):

A good financial system manages risk and allocates capital, with the intent of increasing the overall efficiency of the economy; it does this with low transaction costs. However, we have a financial system which created risk and misallocated capital, with high transaction costs. While capital was being misallocated to homes beyond people’s ability to pay and in places where homes were not needed, too little capital was being deployed to new start-ups, to create and expand small and medium size enterprises, which are the bases of a dynamic economy.

A small part of our financial system, the venture capital firms, is responsible for a large part of our economy’s economic growth. While our big banks have not been at the center of this dynamic growth, they have been at the center of this tempest; they have created risk to our country, without any offsetting rewards—though to be sure those in the industry have been rewarded well.

Other parts of our financial system have done a good job—community banks, credit unions and local banks—in supplying consumers, small and medium sized enterprises with the finance they need.

But we should also be aware of the inadequacies of our financial system—beyond the failures in risk management and capital allocation that led to this crisis. Our financial system discovered that there was money at the bottom of the pyramid and made a concerted effort to make sure that they money did not remain there. They engaged in predatory lending; it is ironic that they were hoisted by their own petard in the sub-prime mortgages.

…we need to admit that those that predicted dire consequences to come from the repeal of the Glass-Steagall Act were correct. They warned about conflicts of interest, the increase in concentration of the banking system, with increasing risks of too-big-to-fail institutions—and increasing systemic risk as a result. They warned about the consequences of transferring the investment banking culture to the commercial banks, who are entrusted with the management of the payment system and ordinary individuals’ savings—insured by the government. The critics suggested that the benefits from economies of scope and scale were exaggerated, and, if present at all, these were almost surely outweighed by the costs. As painful as it may be, we need to revisit these questions. Depression-era regulations may not be appropriate for the twenty-first century, but what was needed was not stripping away regulations but adapting the regulatory system to the new realities, e.g. the enhanced risk posed by derivatives and securitization.

The process of breaking them up may be slow; there may be political resistance—even if the shareholders have not done well, their officers have, and their political contributions have not gone unnoticed.

In environmental economics there is the basic principle of the polluter pays. Those who pollute must pay the cost of clean-up. It is a matter of efficiency and equity. The too- big-to-fail institutions have contributed to the pollution of the global economy with toxic mortgages; they should now pay for the cost of clean-up.

We should recognize that, in a sense, the too-big-to fail institutions have succeeded in managing their risk well—but not in the way advertised. A relatively small investment in campaign contributions (the combined campaign contributions of U.S. financial, insurance, and real-estate firms has been estimated at around $5 billion over the past decade) has succeeded in transferring losses to the public, estimated well in excess of a trillion dollars.

Yes, apparently the too-big-to fail institutions have succeeded in managing their risk — by transferring it, with the help of both the Bush and Obama administrations, onto the rest of us.

(thanks to cbl2 who alerted me of this hearing)

x-posted at oxdown.

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