No Bank Is "Too Big to Fail!"

That’s the argument Nouriel "Dr. Doom" Roubini -- one of the few analysts who foresaw the credit crisis -- makes in an opinion piece he co-authored for the Financial Times this week. Pretty bold stuff, but given the stakes, isn’t it at least worth considering?

Extra capital required = failed institution?
Roubini is mistaken that the market will consider that the banks that require additional capital are failed institutions -- barring them from being able to raise private capital and pushing them into the government’s arms. Both Wells Fargo (NYSE: WFC  ) and Morgan Stanley (NYSE: MS  ) have announced multi-billion dollar common share offerings on the heels of the results -- I expect both of these to be successful.

(The ability of regional banks such as Regions Financial (NYSE: RF  ) , KeyCorp (NYSE: KEY  ) , and SunTrust Banks (NYSE: STI  ) is admittedly less clear-cut.)

How to manage a large bank failure
Even if a large bank failure doesn’t play out during this crisis, Roubini's notion that large bank failure could be managed such that it poses no wider systemic risk warrants some attention. Still, it sounds too good to be true -- how is that possible?

Firstly, Roubini says that the risk of contagion has decreased since the failure of Lehman Brothers last year; in that respect, the stress tests have been helpful in letting investors differentiate between weak and strong institutions. And secondly, the fear of counterparty risk could be mitigated by having the government step in and act as the ultimate counterparty for all trades. This is the role of the clearinghouse in exchanges such as the CME (NYSE: CME  ) .

Finally, the government could guarantee depositors’ assets (to avoid bank runs), while allowing bank creditors to lose money -- who appear absolutely unwilling to consider.

Bring back old-fashioned market discipline
"Too big to fail" is itself a failed concept. The fear of the perceived consequences of a large bank failure is preventing us from imagining a framework within which authorities could unwind a failed institution with minimal disruption to capital markets and the economy. It’s high time authorities stopped hiding behind an idea that has become dogma and settled on a smaller -- albeit a critical, enabling role -- that would allow for the return of market discipline.

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