THE STASH NOVEMBER 10, 2009
Oftentimes when you debate a skeptic of structural reform on Wall Street, the skeptic will say something like: "Why are you so worked up about 'too big to fail'? Lehman was far from the biggest bank on Wall Street, but it caused plenty of damage." If anything, "too-interconnected-to-fail" is the real issue, they'll say--implying that this makes addressing the problem utterly futile, since severing interconnections is a lot harder than limiting bank size.
In my experience, this can temporarily wrong-foot you long enough for the other person to seize the rhetorical advantage. But, as James Kwak points out in a recent Baseline Scenario post, it's really not much of a response at all:
I think this whole “interconnectedness” theme is a clever rhetorical trick — a way of defusing the “too big to fail” argument by making a correct but ultimately minor point. I agree that if you simply cap balance sheet assets, that will not be enough. Technically speaking, a derivatives dealer can have ZERO balance sheet assets yet have an unlimited amount of open derivatives positions. ...
But who said that “big” in “too big to fail” had to mean balance sheet assets? When I say “big,” the concept I am referring to is the overall shadow the institution casts over the financial system and the amount of collateral damage it would cause were it to fail. That damage can take various forms: debt that becomes worthless, derivatives positions that can’t be closed, hedge fund collateral that can’t be pulled back, etc. So call it “too interconnected to fail” or “too systemically important to fail” if you want, but you haven’t made the problem go away. The only thing you’ve done is pointed out that it can be tricky to measure overall importance, but none of us ever denied that to begin with.
Why don't we call it "too spooky to fail" and agree that we don't want to live with anything like it.