Dudley explains why TBTF firms need to shrink
William Dudley claims that there are two sources of instability inherent to financial intermediation. The first is universally recognized: maturity transformation. The second is not:
The second inherent source of instability stems from the fact that firms are typically worth much more as going concerns than in liquidation. This loss of value in liquidation helps to explain why liquidity crises can happen so suddenly. Initially, no one is worried about liquidation. The firm is well understood to be solvent as shown in Figure 1. But once counterparties start to worry about liquidation, the probability distribution can shift very quickly toward the insolvency line, as shown in Figure 2, because the liquidation value is lower than the firm’s value as a going concern.
In his analysis Dudley fails to ask one very important question: When is there a big difference between the liquidation and the “going concern” value of financial firms?
I would posit that for old-fashioned banks that hold loans on the balance sheet and take deposits the difference between the liquidation and the “going concern” value of the bank is not necessarily large. Simple loans are relatively easy to value. Branches can be sold off. Key employees who know the borrowers and have relationships with large depositors can be kept on by the firm that purchases a branch.
Almost certainly too big to fail firms have much higher liquidation costs than old-fashioned banks. Complex asset portfolios are harder to liquidate than simple loan portfolios and are likely to be particularly hard-hit when markets are unstable. Furthermore too big to fail firms are frequently too large to be managed well even when they are going concerns and thus must be split in many, many pieces in liquidation. The process of selling off divisions will inevitably lead to some loss of information as employees with broad experience must go in one direction or another.
I read Dudley’s second source of instability as a reason to protect the financial system from oversized financial supermarkets.