Baxter, Hynes debate what should be done about companies deemed "too big to fail"

March 11, 2010Duke Law News

In a new book chapter, two members of the Duke Law faculty square off on the hot-button issue of whether the federal government should ensure that no firm is too big to fail.

In Debating Reform: Conflicting Perspectives on How to Fix the American Political System (Richard J. Ellis and Michael Nelson, eds., CQ Press, 2010), Lawrence Baxter, a visiting professor of the practice of law and former bank executive, argues that the government should, in fact, make sure that corporations don’t grow so large that their failure would threaten the overall economy. When government money has to be used to help a corporation avoid a bankruptcy that would be economically and societally disruptive, he writes, “our economic and regulatory systems have failed and the result is a system of private enterprise subsidized by government and, ultimately, by taxpayers. This is contrary to the fundamental principles of our economy and, ultimately, is damaging to the general welfare.”

Taking the contrary view, Terence Hynes ’79 argues that market forces should be left to determine the optimum size and scope of businesses. A practicing attorney at Sidley Austin in Washington, D.C., and a senior lecturing fellow at Duke Law, Hynes asserts that corporate size was not the root cause of the recent economic meltdown, and that breaking up large companies will not “insulate the United States from future economic turmoil. To the contrary, government-imposed limitations on the size of U.S. companies will hamstring their ability to compete successfully in an increasingly global economy and, ultimately, reduce rather than enhance America’s economic growth and prosperity.”

Here are their arguments, in brief.

Baxter: “The consequences of economic gigantism can be ruinous”
  • Bigger is not always better, even for the businesses concerned. In an economic culture highly supportive of sequential mergers, due diligence often was done in haste, leading to a general overestimation of savings and underestimation of human and actual costs. “The new, larger companies are difficult and inefficient to manage.”
  • Taxpayers, not just shareholders, have to absorb the costs of the actual or threatened collapse of very large organizations. “The costs of the failure of these institutions have been externalized to the public in the form of taxpayer-backed government assistance.”
  • Bailing out huge institutions with government loans “on terms that no private source of capital could match” lessens the threat of bankruptcy and effectively undermines free market discipline. “..[O]ur modern economy is becoming populated by a growing portfolio of what many commentators have called ‘zombie’ organizations: too big to fail and too big to make profits for shareholders (as opposed to their highly paid executives).”
  • Unchecked growth in corporate power can undermine democracy. The always large political influence of big companies is amplified when politicians fear that a corporate failure can pose a systemic risk to the economy. “Some of the biggest political contributors were the same companies that received massive government assistance to bail them out. … A good deal of the money these companies spend on lobbying is meant to influence perceptions about the performance of and risks generated by such organizations.”

What should be done? Proposals to separately regulate just those “systemically significant” companies with extensive financial interconnections don’t go far enough to protect the public, Baxter maintains. The government, he says, has both the power and the obligation, through financial services regulation, to prevent the growth of corporations — financial and non-financial — to the point where they become too big to fail.

“This does not mean that government should start tearing apart every large company. Rather, government should not allow a company to get larger if to do so would significantly increase the risk that the company will become too big to fail.”

Hynes: “Regulate behavior, not size”
  • Size is not the problem. “The root cause of the crisis was the behavior of mortgage lenders (both large and small) seeking to cash in on the housing boom by making increasingly risky loans, of Wall Street firms that issued and traded in ‘derivative’ securities backed only by portfolios of those risky loans;” when the housing bubble burst and financial institutions were left with billions in “toxic” assets on their balance sheets, those institutions could not access funds to offer credit.
  • The “interconnectedness” of financial institutions, not their size, caused the crisis; they routinely borrow from and lend to one another. “Government intervenes when the failure of one firm (or group of firms) could have harmful ‘spillover’ effects on other firms and the overall economy — nationally and globally.
  • Earlier government bank bailouts — and the 1979 Chrysler bailout — set precedents and created expectations that undercut free market forces. “This … weakened the incentive of shareholders and creditors to monitor and restrain the level of risk undertaken by financial institutions that are perceived to be ‘too big to fail.’”

What should be done? “The ‘too big to fail’ problem cannot be solved by dismantling America’s largest financial and industrial firms, or by placing artificial limits on their size,” Hynes argues. “Instead, an effective response must seek to curtail the types of excessively risky behavior that gave rise to the credit crisis, and to restore the market discipline that has been undermined by the perception that government will inevitably rescue large corporations from the consequences of high-rise business strategies.”

Hynes says that financial reforms recently proposed by the Obama administration correctly focus on behavior, rather than size, requiring that firms retain a financial interest in and, thus, share the risk of, the high-risk derivatives they issue. Corporate bailouts should be few and far between and strict limits should be placed on corporate lobbying and campaign contributions. But “by stunting the natural growth of firms, society will forfeit the economies of scale and scope that lead to greater efficiency and reduce the cost of products and services.”
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