the Theory of Large Numbers
Henry C.K. Liu
This article appeared in AToL on November 19, 2009 as Failure
written into 'too big' policy, and also on
NewDeal 2.0 Project of the Franklin and Eleanor Institute as: Coming Implosion: Too Big To
Fail and the Theory of Large Numbers
The potential failure of banks deemed too big to fail (TBTF) presents
challenges for policymakers. The unacceptability of the systemic impact
failures on the financial, economic and social order necessitates
intervention in a market crisis. Thus far, official response to the
has been focused on unlimited government protection of big bank
losses they otherwise would face from big bank failures. Yet creditor
expectation of TBTF protection actually encourages big banks to take
thus pushing them closer to the cliff of failure, resulting in
net costs to the economy and society.
The Obama administration and Congress are now trying to address the
issue of TBTF, generally acknowledged as a key contributing factor to
collapse of the global financial system in 2008. Yet, government
programs for big financial institutions have resulted in banks becoming
bigger than before the crisis. Apparently, the administration’s
“too-big-to-fail” is to make banks bigger.
JP Morgan Chase is reportedly holding more than $1 of every $10 on
the US. The four biggest super banks (JP Morgan Chase, Bank of America,
and Citibank) now issue one of every two mortgages and about two of
credit cards in the US.
Since the financial crisis, these four super banks are each allowed to
more than 10% of the nation’s deposits, having been exempted from a
rule barring such market dominance. In several metropolitan regions,
super banks are now permitted to take market share beyond what the
of Justice's antitrust guidelines previously allowed. Such
concentration of market share will hurt consumers in two ways. It will
cost of credit high to borrowers for lack of competition even when cost
of fund for banks
low. It will also push bank reserves upward to
banks to pass on the cost to borrowers. The American
system is now one of a handful of large global trading companies
be banks, taking huge profit from high risk proprietary trades with
government-backed money, instead of one of a network of small
institutions serving their domicile communities merely as
money through local deposits for nominal fees.
Sheila C. Bair, chairman of the Federal Deposit Insurance Corp,
TBTF problem as: "It fed the crisis, and it has gotten worse because of
financial system is looking more like a financial trust of a small
super banks operating with deliberate moral hazard backed by ever ready
government bailouts, while consumers are increasingly faced with fewer
financial services from competitive providers.
The Obama administration’s efforts to introduce a new
regulatory regime to prevent recurring financial crises triggered by
institutions leans towards imposing higher capital standards on these
financial institutions and empowering the Federal Reserve as a super
take over a wider range of troubled financial firms to wind down their
businesses in an orderly way with minimum loss to depositors.
adequate capital is necessary for sound banking, the problem with the
system today is that it is infested with high risk propriety trading
the conventional bank capital requirements cannot possibly handle.
Treasury Secretary Timothy F. Geithner declares the dominant
public policy imperative motivating reform as “to address the moral
created by what we did, what we had to do in the crisis to save the
Yet there is little evidence that moral hazard is being reduced or the
is being saved. What has been saved was the elite segment of the
financial industry at the expense of the long-term health of the
moral hazard is now the accepted operative mode for super banks.
Latest FDIC data reveal that the new super banks now can
borrow more cheaply than their smaller peers because creditors assume
large institutions to be fail safe. This trend will leave the financial
dominated by a gigantic trust of interlocking super banks.
Since the crisis, JP MorganChase, Bank of America and Wells
Fargo and Citibank are each allowed to hold more than 10% of the
deposits despite a long-standing rule barring such a practice. In
metropolitan regions, these banks are now permitted to take market
what the Department of Justice’s antitrust guidelines previously
The White House plan as outlined so far would allow these
super banks, whose failure would put the financial system and the
risk, to continue to exist, but would make it much more costly for them
provide financial services to the public. The plan would force such
institutions to hold more funds in reserve and make it harder for them
borrow too heavily against their assets. The plan would require that
these super banks to come
up with their own procedure to be disentangled in the event of a
crisis, a plan
that administration officials say ought to be made public in advance,
presumably to impose market discipline on the largest and most
companies. Since banks exist to make profit, the bottom line is that
banking services will increase for both corporate borrowers and the
The administration’s plan merely passes the cost of moral
hazard to consumers. What needs to be done is to break up these super
banks and the
trading firms that pretend to be banks into regional institutions
financial firebreaks to prevent systemic contagion, and to impose
on circular hedging. But the administration and its Congressional
continue to reject such proposals.
Mervyn King, governor of the Bank of England, and Paul A.
Volcker, former Fed chairman, have separately suggested sweeping steps
the nation’s largest financial institutions to divest their riskier
King called for the revival of Glass-Steagall, a New Deal legislation
separated investment banks from commercial banks.
The solution to the “too-big-to-fail” dilemma intuitively
lies in preventing institutions from getting too big. Yet because of
interconnection of markets, even failure of small entities in large
trigger systemic failure. This gives even entities of similar risk
not too big individually, the ability to cause systemic failure.
In mathematics, the theory of large numbers includes the phenomenon of
exponential growth which occurs when the growth rate of a mathematical
is exponentially proportional to the function’s current value. Such
growth is mathematically unsustainable and will eventually implode.
Multilevel marketing is designed to create a large marketing force by
compensating not only for sales it generates, but also for the sales of
marketing forces each market force introduce to the company, creating a
limitless down-line of distributors and a hierarchy of multiple levels
compensation in the form of a pyramid, such as that employed by Amway
Corporation. The crisis in sub-prime mortgage is caused by massive
marketing, even as each subprime mortgage individually is only a small
No bank, however big and well capitalized, can withstand the onslaught
systemic breakdown of market-wide counterparty exposure built by
marketing of liabilities such as subprime mortgages and their
Thus the problem of systemic market failure is caused not merely by
bigness, but also by the absence of firebreaks to prevent unsustainable
growth in risk exposure and the resultant systemic contagion effect of
failures from chained counterparty reaction. It is hard to understand
policymakers are not cognizant of this obvious fact enough to focus on
for firebreaks in interconnected financial markets to both prevent the
risk chain reaction and to contain systemic failure contagion.