Gary Stern on Too Big to Fail

Risk Incentives

The discussion on risk incentives highlights how expectations of government bailouts influence financial institutions' behavior. Gary Stern explains that when creditors anticipate protection, they have little motivation to monitor the risks taken by institutions, leading to mispriced risk and excessive risk-taking 1. This mispricing encourages firms to leverage more than they would otherwise, as seen in cases like Bear Stearns and Lehman Brothers, where firms took on significant leverage due to cheap borrowing costs 2.

If creditors expect to be protected, then they have no incentive to worry about the risks the institution is taking, which is just another way of saying that risk taking is mispriced.

--- Gary Stern

Russ Roberts adds that in a "too big to fail" environment, firms are incentivized to increase leverage, betting more of others' money, as creditors feel secure in the likelihood of bailouts 3.

   

Creditor Expectations

Creditor expectations play a crucial role in financial stability, particularly in a "too big to fail" context. Gary Stern notes that periods of financial tranquility, like the one before the recent crisis, can lead creditors to expect government leniency, as seen in past episodes like the Mexican crisis 4. This expectation of forbearance, where institutions are given time to recover rather than being rigorously evaluated, can lead to complacency among creditors 5.

If you communicate to the creditors in advance the nature of your preparation and the reason behind it and so on and so forth, you'll get better pricing of risk taking in the marketplace.

--- Gary Stern

Stern argues that better communication and preparation could lead to more accurate risk pricing, potentially reducing the likelihood of future crises 6.