The Risk Externalities of Too Big to Fail

Abstract (Via SSRN)

This paper examines the risk externalities stemming from the size of institutions. Assuming (conservatively) that a firm risk exposure is limited to its capital while its external (and random) losses are unbounded we establish a condition for a firm to be too big to fail. In particular, expected risk externalities’ losses conditions for positive first and second derivatives with respect to the firm capital are derived. Examples and analytical results are obtained based on firms’ random effects on their external losses (their risk externalities) and policy implications are drawn that assess both the effects of “too big to fail firms” and their regulation.

Additional Excerpts (Via SSRN)

The essential question is therefore can economies of scale savings compensate their risks. Such an issue has been implicitly recognized by Obama’s administration proposals in Congressional committees calling for banks to hold more capital with which to absorb losses. The bigger the bank, the higher the capital requirement should be (New York Times, July, 27, 2009, Editorial). However such regulation does not protect the “commons” from the risk externalities that banks create and the common sustains. To assess the effects of size and their risk externalities, this paper considers a particular and simple case based on a firm risk exposure which can lead to a firm’s demise (its capital) and unbounded external losses for which they assume no consequence. An example is used to demonstrate that such risk exposure underlying excessive risk taking (motivated by the lure for short term profits) can have accelerating losses the larger the bank

Conclusion (Via SSRN)

The purpose of this paper is to indicate that size matters and its risk externalities may be too big to bear— in which case firm may be too big to fail. Such firms are “polluters” either by design when they overleverage their financial bets or speculative positions and are struck by a Black Swan [13], [14]. While capital set aside (such as VaR—V alue at Risk) may be used to protect their internal losses, such approaches are oblivious to the far morte important risk extrnalities. For this reason, such firms require far greater attention and far more regulation. Internalizing risk externalities by ever larger firms is in such cases inappropriate since the moral hazard and the market power resulting from such sizes will be too great. Similarly, total controls, total regulation, taxation, nationalization etc. are also a poor answer to deal with risk externalities. Such actions may stifle financial innovation and technology and create disincentives to an efficicent allocation of money.

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