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Governance Not Regulation

di - 14 Aprile 2009
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APPENDIX

Defining “Fail

Sometimes when economists use the word “fail” a definition of exactly what is meant is unnecessary. An example of this would be the phrase “…a wave of bank failures swept the southern states of the USA”. That phrase, from the discussion of the consequences of the failure of Cauldwell and Co. of Nashville, is taken from Friedman and Schwartz’s “A Monetary History of the United States”. In that context further definition is unnecessary, for what was relevant was that such a wave followed from a surge in the demand for cash (instead of bank deposits) following the closure of an important bank and unchecked could have continued still further, because of that same surge in demand. In the context it was immaterial how much capital bank shareholders eventually got back, for the concern was not with them but with depositors.
But for shareholders, and creditors other than depositors, the meaning of fail is crucial. Several issues have to be clarified. How much of their funds did they eventually get back? When did they get it? When did they know they would get something back? When did they know how much they would get back? The answers to these questions are surely likely to affect their behaviour.
But answers are seldom provided. Rather it is simply assumed that the word “fail” has an unambiguous meaning, and subsequent behaviour then deduced.

There is also discussion of the consequences of a big bank failing, and what the monetary and perhaps fiscal authorities should do about this failure. This, aside from neglecting the above issues, also ignores an important fact. Banks the overnight failure of which would disturb the whole banking system, and perhaps the financial system more generally, rarely fail overnight. Indeed, no example exists in British banking history, and in the USA the case of LTCM (not a bank in any case) is arguable. Rather they decline slowly. From Britain consider the now defunct Midland Bank. In the 1930s (just after it opened its magnificent head office in Poultry, just across the road from the Bank of England), it was the biggest bank in the world. It steadily declined, suffered the ignominy of receiving a takeover bid from its advertising agency, and was eventually taken over by HSBC. That process took some 50 years. In the USA the failure of Continental Illinois, though often described as an overnight collapse, actually was not. Many of its counterparty banks and other financial institutions had noticed the increased riskiness of its lending, and had reduced or eliminated their exposure to it before the collapse came.
To summarise, the word “Fail” should be used carefully.

References

Benston, G. J. (1969) The Effectiveness and Effects of the SEC’s Accounting Disclosure Requirements, in H. Manne (ed) Economic Policy and the Regulation of Corporate Securities AEI, Washington, DC

Dupui, J. (1844) De la Mesure de L’utilité des Travaux Publics, Annales des Ponts et Chaussées, Paris. Scientifiques et Medicales Elsevier

Grossman, S and Hart, O. (1983) An Analysis of the Principal-Agent Problem, Econometrica 51: 7-45

Hume, D. (1740) Treatise of Human Nature, Oxford: Oxford University Press

Loeb, M. and Marget, W. (1979) A Decentralised Method of Utility Regulation, Journal of Law and Economics 22: 399-404

Myddleton, D. (2004) Unshackling Accounts IEA, London

Pauly, M.V. (1974) Over insurance and Public Provision of Insurance: The Roles of Moral Hazard and Adverse Selection, Quarterly Journal of Economics 88: 44-62

Ross, S. (1973) The Economic Theory of Agency; the Principle’s Problem, American Economic Review, G3, 134-139

Smith, A. (1776) The Wealth of Nations, New York, The Modern History

Stigler, G. J. (1975) The Citizen and the State, University of Chicago Press, Chicago

Vickrey, W. (1960) Utility, Strategy and Social Decision Rules, Quarterly Journal of Economics, 74: 507-535

Wicksell, K. (1896) see p. 412

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