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Notes to myself, possibly of interest to others.
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Wednesday, March 23, 2011

The Doom Loop: Banking System Becoming Too Big To Save

Simon Johnson of The Baseline Scenario has a post at Project Syndacate which makes several good points in follow-up to his book 13 Bankers which argues that banks should be down-sized:

...the financial sector in the US and globally has become much more unstable in recent decades, and there is nothing in any of the reform efforts undertaken since the near-meltdown in 2008 that will make it safer.

People sometimes talk about “systemic risk” as if it were intrinsic to the financial system. But modern financial history, including in emerging markets, strongly indicates otherwise...

The three people who have articulated this problem most clearly include two of the world’s leading central bankers. Before Ben Bernanke became Chairman of the Federal Reserve Board, he was rightly renowned for his academic work on the Great Depression, which showed how, under the right (or wrong) conditions, the financial sector could act as a form of accelerant for developments in the real (nonfinancial) economy...

Anat Admati, a professor at Stanford’s Graduate School of Business, focuses on bank capital – specifically, the incentives that banks have to fund their activities with very high leverage – little equity and a great deal of debt. In my view, she has the single most important page on the Web today (http://www.gsb.stanford.edu/news/research/admati.etal.mediamentions.html), containing both original research by her, Peter deMarzo, Martin Hellwig, and Paul Pfleiderer and their many interventions in the policy debate...

Mervyn King, a former academic who is currently Governor of the Bank of England, and his colleagues have a vivid name for the toxic cocktail that results: “doom loop.” The idea is that every time the financial system is in trouble, it receives a great deal of support from central banks and government budgets. This limits losses to stockholders and completely protects almost all creditors...

America’s too-big-to-fail banks are well on their way to becoming too big to save. That point will be reached when saving the big banks, protecting their creditors, and stabilizing the economy plunges the US government so deeply into debt that its solvency is called into question, interest rates rise sharply, and a fiscal crisis erupts.

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