Why 'Too Big to Fail' is Too Short-Sighted to Succeed: Problems with Reliance on Firm Size for Systemic Risk Determination

Mon Jan 18 15:24:38 EST 2010
By Dr. Sharon Brown-Hruska, Dr. Robert Mackay, and Dr. John Bovenzi of Oliver Wyman Group, et al.

In this report, prepared for Property Casualty Insurers Association of America, the authors discuss why relying on size as the primary determinant of financial institution systemic risk is inappropriate, and describe negative economic consequences likely to result if a sized-based process is used in financial reform legislation. The authors note that, while several large financial institutions significantly contributed to the systemic risk episode recently experienced, absolute size is not an appropriate proxy for a firm's systemic risk contribution. They find that legislative proposals that rely on a size-based identification process would erroneously identify a number of financial firms as systemically risky, when in fact they are not. Meanwhile, other firms that do in fact pose significant systemic risk would fail to be identified. If enacted, the authors argue, such legislation would create a cross-subsidy of significant magnitude from firms that do not pose systemic risk to those firms whose activities are systemically risky. The resulting moral hazard would encourage increased risk-taking and, as such, could ultimately defeat the legislation's intent of reducing the economy's exposure to systemic risk.