"Too big to fail" is hardly a new idea -- especially for this year's Nobel Prize in Economics winner. French economist Jean Tirole has been taking on too-big-to-fail (TBTF) issues for more than two decades. From market regulation to monopolies to intellectual property, Tirole takes theory and turns it into real-life lessons to deal with some of today's biggest economic problems. Here are his three most important insights on the idea of TBTF.
1. Size doesn't matter
JPMorgan Chase & Co. (NYSE:JPM), Bank of America Corp (NYSE:BAC), and Wells Fargo & Co (NYSE:WFC) all have over $500 billion in assets. But does that make them too big to fail? Not necessarily, says Tirole in a Bloomberg Television interview:
Size is a complex matter because you can be a big bank that is diversified and, conversely, the smaller banks, they can fail. ... It's not only size that matters.
The Frenchman points out that sheer size, or even monopoly power, isn't enough to make a corporation too big to fail.
Three factors that potentially matter more than size are liquidity, diversity, and transparency. On the liquidity front, banks need to be able to pay up fast and fully if things take a turn for the worse. Diversity ensures that a single market (see: real estate) can't take down an entire institution. And transparency gives regulators real information to make sure banks live up to those two previous standards.
Big banks aren't necessarily the ones to fail-it's cashless corporations with too many eggs in one basket.
2. Throw out assumptions
Economists are often derided for their unlikely assumptions (e.g., "all humans are rational") and abstract models (e.g., "supply and demand will balance"). Not Tirole.
The French economist doesn't subscribe to any simplified school of thought, instead advocating for extremely precise analysis and regulation. In its 52-page summary of why Jean is prize material, the Nobel Committee put it this way:
He has consistently derived his results from fundamental assumptions about preferences, technologies ... and information asymmetries, eschewing the convenient but ad hoc assumptions that had previously seemed necessary in order to make analytical headway.
The Committee (and Tirole) note that policy needs to be "carefully adapted to every industry's specific conditions." While that might mean a bigger burden for regulators and bureaucratic nightmares for too-big-to-fail corporations, it ultimately makes sense. For example, although Google Inc (NASDAQ:GOOGL) and Apple (NASDAQ:AAPL) are both behemoths in the tech world, they are subject to different regulation to ensure that they and their competitors keep innovating. Given society's ever-increasing ability to create, manage, and share data, it's high time regulation catered to each industry.
3. Play nice
Investors and policymakers often pick sides regarding whether corporations should be regulated more or less. But as Tirole notes, "Regulation is not about preventing firms and banks from functioning. It's the reverse. Regulation is about the rules of the game, and also an independent enforcement of the rules of the game." Framing regulation as a question of "more" or "less" misses the point entirely.
When describing rules, Tirole instead uses the word "strong." With specific and achievable incentive structures in place for both regulators and corporations, rules that are enforceable and effective create an environment for safe and reasonable growth.
And Tirole recognizes the importance of specificity better than most. In a 1996 economic paper, Tirole outlined in striking detail not only the symptoms that led to the Global Financial Crisis, but also regulators' inability to address these issues. Their "creative ambiguity" left too much wiggle room, creating systemic risk that Tirole said "may trigger a chain of subsequent failures and therefore force the central bank to intervene."
How's that for a prediction?
Are we there yet?
Tirole's and other economists' suggestions have already gone a long way toward solving the TBTF banking issues that mushroomed the Great Recession's impact. But Tirole says it's too early to tell whether regulators have done enough.
He points to some improvements, such as more liquidity and the proposed banking union in Europe. allows for collective decision-making and mandates. However, he is quick to note that the details of both initiatives will ultimately determine their effectiveness. And as economists like Tirole are all too aware, even Nobel Prize winners don't have all the answers -- and even if they did, not everyone would listen.
Perhaps Tirole's best advice to regulators is that TBTF is still a serious issue, and without serious regulatory efforts, TBTF organizations will continue to pose a threat to economies around the world.