Size isn't everything

Tim Geithner is a man with a plan. The US Treasury’s six-point agenda to tackle systemic risk looks broadly sensible. A key measure is to identify banks, insurers and other firms that are too big to fail and make them hold more capital. It won’t be easy to do – practically or politically – but it might reduce the too-big-to-fail problem by discouraging size.

One key Geithner proposal centres on the idea that certain institutions – including, for example, insurers like American International Group as well as big banks – can become too large and interconnected to be allowed to fail, and should consequently be regulated especially tightly.

That could involve requiring them to have tougher risk controls and bigger capital cushions than other firms, to build capital up in good times, to have lower levels of leverage and so on.

That makes sense – and in today’s complex and inter-related financial markets it is a big improvement on the traditional method, exemplified by the old Glass-Steagall rules, of trying to regulate strictly by an institution’s legal form.

However, the plan has its problems. For one thing, it requires a definition of “too big to fail”. Then setting the regulations – and deciding which bits of government implement them – will be a practical and political minefield. That’s also true of the criteria for any decisions to step in and wind big institutions down. The government’s power to do that is currently limited to banks, and Geithner rightly wants to extend it to the likes of AIG.

As he recognises, such a shift would require a level of international cooperation to avoid firms shopping around for the easiest regulatory systems. Even at home, insurers can, for instance, claim that key subsidiaries are already regulated state-by-state already. The makings are there for a political bunfight.

So although Geithner may be on the right track, it won’t be easy. But the two-tier approach to financial institutions, if he can push it through, would be a clever move. It would almost amount to a too-big-to-fail tax. Certainly, most financial firms would be eager to avoid the constraints involved. That could encourage more of them to stay – or even become – small enough to fail.