Letting Bear fail

This is a tubelight post. Was supposed to have written this two months back.

I sometimes wonder if the US Fed did the right thing by encouraging JP Morgan to buy out Bear Stearns rather than to just let the latter fail. I know letting it fail would have had significant negative impact on the already struggling financial sector. But wouldn’t it have sent out a nice message for the longer term? That nobody was too big to fail? Wouldn’t this have significantly improved the quality of derivatives contracts in the long term?

Several alternative measures have been suggested. “Regulate bankers’ salaries”, hordes of people have cried, prominent among them being Raghuram Rajan and Martin Wolf. “Improve legislation and capital controls”, others have said. Tyler Cowen and Megan McArdle have given huge lists of what could be done (it was because of this that I was reminded of this unwritten post). Obama’s economic adviser Austan Goldsbee has said that if Obama wins, investment banks will be as tightly regulated as commercial banks.

However, I think the easiest method of regulating these banks would have been to convince them that they are not too big to fail. Yes, they allowed Bear to almost fail, and its shareholders almost got wiped out. However, my belief is that this episode will be quickly forgotten and people will be back to the same old risky practices once the current crisis is over.

What if Bear would have been allowed to fail? People with whom it transacted would have all lost tonnes of money. So how would that have helped? Basically, in future, banks would become more wary of counterparty risk. They would be continuously monitoring each other. If one guy behaved badly, other banks would stop talking to him. Which would push up the level of everyone’s behaviour. I think being boycotted by your friends is a bigger punishment by being caned by the teacher.

What has happened is that Bear has been kicked out of the school (effectively), and JP is the biggest boy in class now. The rest are mostly unaffected. If one of them behaves badly, the others will let him do that. They have no incentives to make him behave well.

Now, what if , apart from Bear getting kicked out, the others had been fined a thousand rupees each? For the fault that they didn’t try to correct Bear when he started behaving badly. Wouldn’t this ensure exemplary behaviour from the kids henceforth? And allow the teacher to concentrate on more important things such as teaching?

Taking another analogy, this is exactly how the famed Grameen Bank works. People are divided into groups, and if one person in the group behaves badly, i.e. doesn’t repay loan, the rest of the group will be punished by not being eligible for a loan. It is this that has led to the exemplary rate of payments in Grameen Bank. It is this collective responsibility that has made it a success. It is now time, I think, to take this idea from micro-finance and apply it to the highest levels of finance in the world. One opportunity (Bear) has passed. It remains to be seen what the fed will do when the next such opportunity pops up.

PS: This is not in my personal interest. I’m currently on a career break, and am trying to break in back into the world of investment banking.

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