The recent implosion of MF Global has reignited the debate over Too Big to Fail (TBTF) and the adequacy of U.S. regulatory safeguards. It has also contributed to a broader decline in investor sentiment, many of whom believe the market structure does not afford them sufficient protection and fair competition. Many MF Global clients still have assets frozen and even if they ultimately recover the money, the short-term consequences can be devastating.
Historically, when firms fail to generate a profit or when one division damages the revenue stream of the whole firm the unprofitable assets are divested. Companies that can’t operate under the weight of their own size end up spinning off the parts that caused the pain. This is normal in the business cycle. The government has disrupted the business cycle of creative destruction by championing TBTF firms over a more competitive market.
The Final Four
Is concentrating this much risk the hands of so few banks good for the market?
At its root, TBTF is a triumph of lobbying over market structure. When Congress passed the No Child Left Behind Act in 2001, no one expected it would create a perfect safety net. Fast forward to 2011 and the legislation is intensely criticized for its design flaws and implementation. In short, the Act failed to live up to its lofty title. Too Big to Fail is a similar misnomer. TBTF is nothing but a marketing ploy masquerading as a market reality, a costly illusion expedited by bank lobbyists and political insiders. If anything was really too big to fail, there would be no need to label it as such because it would be self-evident. No firm was too big to fail, and no firm is too big to fail. The future will prove this out.
The official (and unofficial) recognition of TBTF firms has led to a number of unsavory and unsafe business practices. Businesses overvalued balance sheets, and engaged in questionable practices to grow even bigger and support non-profitable divisions. The Federal Reserve tacitly encouraged these maneuvers through its monetary policies. The end result was consolidation upstream and a loss of diversity in financial counterparties. In the end the Federal Reserve will be the only counterparty, backstopping one huge bank or an exchange that is partially owned by the banks. When 80% of a firm’s business comes from 20% of its clients the business is too dependent on too few counterparties. The financial industry has been consolidating for the last decade, and the systemic risk is larger than ever before.
As the market continues to trend towards a small number of large, homogenous counterparties we will see OTC and floor locals go out of business and mid-sized firms over-leverage and struggle. Clients without political connections have assets frozen and lost. Liquidity will suffer.
The decreased liquidity is notable already and the CME Group recently lowered margin requirements in an attempt to facilitate an improvement. This is the equivalent of a central bank lowering interest rates and will create more volatility in exchange for liquidity (but does not reduce risk). Similarly, much like the infamous liquidity trap, it will also face a point of diminishing returns.
We expect the consolidation upstream to continue as championed firms eat the client books of their smaller counterparts.
FMX Connect for ZeroHedge