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Too big to fail or too big to survive?

New buzz words in the street since the rescue of Citi in US, RBS in UK and UBS in Switzerland involve Darwinian processes, dinosaurs and other apocalyptic analogies. One may ask, are the world largest financial conglomerates the strongest pillars that will remain once the tidal wave sets off, or are they instead to big to adapt?

Given the market conditions, there is no way that anyone with a US$30 bn and above exposure to the mortgage market would remain unaffected. Now unless risk was left unhedged or serious miscalculations, the financial institutions know how to allocate capital for systematic risks within their field of activity. Problems occur when the hedges against several types of systematic risk combine into systemic risk. For example, the bridges thrown between the loan book management and securities underwriting activities following the official dismissal of Glass Steagall in 1999 have been a media of asset contamination. The uniform rules for netting credit exposure, and the model-based capital allocations inspired by Basle, led to under-capitalisation and over-exposure to tail risks. MIFID indirectly leads to conflict of interests that may result from funding and simultaneously executing trades. UCITs encourages institutional investors into derivatives, the list is long. Ironically, most systemic risks have resulted from the regulators' efforts to address some of the systematic risks.

The regulatory alphabet soup will end up clearing and the giant financial institutions will always exist. What's vanishing is that technocratic dream of a world without border where capital moves freely between asset classes, markets and portfolios. The one-bank model is gone and the giants will now come down to human size business. Insurance will do insuring and hedge their exposure accordingly, banks will focus on banking. Private banks will no longer invest their customers' money on investment banking bets. Brokers will not become exchanges. Cross netting exposure from sell-side to buy-side divisions will most likely be forbidden or at least strictly controlled by some new set of regulations (whereas it was previously encouraged). Businesses will not necessarily be chopped by geography or activities, but by "financial ecosystems" defining themselves through the very rules and methodologies available to manage risks within. For example, some financial ecosystems hinge on established rules and practices for settlement and counterparty risks, legal frameworks, hedging technique, liquidity risks and by the abundance and accuracy of (or lack of) available information.

Welcome back to the human size banking model, down here on Earth, where risk is managed one silo at a time.


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