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'TBTF' at its best...yet again - Views on News from Equitymaster
 
 
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  • Sep 23, 2008

    'TBTF' at its best...yet again

    Here is an old but interesting story of two friends who went to a jungle. They saw a hungry lion there. As soon as they saw the beast, they understood that they are going to be history. One of those guys took a pair of brand new shoes and started wearing them. His friend was surprised at his action and asked him, "Do you think that you can run faster than the lion with those shoes on?" This guy replied him, "Dude, I need not run faster than the lion. I just need to run faster than you!"

    So, what is the moral of the story? You have to be fast enough to survive in this competitive world. In the parlance of financial markets, you have to be 'too big to fail' - TBTF!

    Wikipedia explains the TBTF policy as the idea that in banking regulation the largest and most powerful banks are 'too big to (let) fail', which ultimately means those banks would have less incentive to practice thrift and sound business practices, since they would expect to be bailed out in the event of failure.

    Mr. Ajit Dayal, the co-founder of Equitymaster explains the concept even more simply - "In banking terminology there is a saying - 'If your customer owes the bank a little money, that is fine because the customer will always be in trouble since he owes you (the bank) money. However, if the customer owes the bank a lot of money, then the bank is in trouble!' If that large customer fails to pay back the large loan from the bank, the bank may be bankrupt!"

    He goes on to say, "The same equation applies to the size of the financial institution or bank: the bigger the bank, the less likely it will be allowed to die a natural death and 'fail'. Because of its sheer size the closure of such a financial institution is likely to have a larger impact on the economy and the financial system in general."

  • Also read - Habits die hard: TBTF

    It is this very policy of TBTF that has saved the likes of Freddie Mac, Fannie Mae and AIG in the US, while the 'too small to be saved' breed like Bear Stearns and Lehman Brothers were allowed to die (in some way or the other).

    And now, the US government and Fed have laid the path for formation of a few more TBTF kind of institutions. The conversion into bank holding companies of investment banks like Goldman Sachs and Morgan Stanley is ideally a way that will make them TBTF.

    A report on Bloomberg clearly brings out the entire picture. The report talks about how the takeovers of Merrill Lynch and Bear Stearns will increase the liabilities of Bank of America and JPMorgan Chase respectively by big amounts. Specifically, the latest deal (between Merrill and Bank of America) will boost the latter's liabilities by a whopping 60% to US$ 2.5 trillion.

    And then there is Citigroup, which has almost US$ 2 trillion of liabilities. This makes all these three banks TBTF. The report on Bloomberg further reports - "It might be a better idea to prevent banks from growing to the point that we couldn't accept their failure. The problem is not the combination of banking and securities per se. It's a function of sheer size."

    And you know what, we have some live examples of the TBTF kinds in India as well. Ajit puts it very clearly - "IFCI, ICICI, and IDBI were all developmental financial institutions that lent good money to bad projects. By 1999 many of these financial institutions were in trouble. Why? Because there were a few larger business houses that owed them a lot of money and, since industry was in bad shape, no one could pay so these financial institutions were in trouble and needed to be rescued by a combination of money, change in management, or change in business strategy. Today, all 3 institutions stand alive - some prospering, some tottering. But they stand."

    "Over the same time period, many smaller banks and cooperatives have been shut down. These smaller banks made the same mistakes as the larger banks and institutions but they were not likely to have such a large impact outside a specific geographical area. So they were allowed to 'fail'."

    There you have it. TBTF works…in the US, in India, everywhere!

     

     

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