Are We All “Too Big to Fail”?

Posted on December 15, 2012

Are we all “too big to fail”?

Governments around the world rushed in to pump taxpayers’ money into failing banks that were considered too big to fail. The banks were universally castigated and the political leaders were widely criticized.

Governments in developed countries rushed in with taxpayers’ money to help people whose homes were struck by flooding. They were universally praised for the rapid humanitarian response.

These two situations might seem totally different – as are the political consequences of intervention. But are there similarities that we should not forget?

Banks were badly managed and took risks that they should not have done. As a result they consumed, and continue to consume, large amounts of taxpayers’ money. Some argue that when banks are “too big to fail”, they have little incentive to avoid taking unmanageable risk; they benefit from the upside and are bailed out of the downside. Hopefully new bank regulation will correct some of these issues.

What of flooding?

That’s a “natural disaster” one might argue. It is not the fault of those who are caught by the flooding. Government is there to help those in need and save lives.

Some of this is true. But it ignores one important element. Developers choose to build in areas that are prone to flooding. Individual choose, of their own volition, to buy housing in areas known to be prone to flooding. And some governments further enhance the risks by subsidizing the cost of insurance in these areas since insurance companies are not foolish enough to insure except at unaffordable prices. We therefore, with government complicity, continue to create the conditions that lead to loss of life plus the same type of moral hazard that we see with banks – if something goes wrong the government will bale you out.

The adjacent map shows a suitability analysis for Staten Island. The parts of the island that had to be evacuated following Hurricane Sandy (left hand side image) are almost identical to sites identified as unsuitable for urbanization (right hand side images). In the UK, a recent report by the government’s climate change adaptation sub-committee states that “development in the floodplain grew at a faster rate than elsewhere in England over the past ten years.” Although some, though not all, of these developments had flood protection, the effects of climate change and of other developments in the area will likely mean that such protection will soon become inadequate and “leave a legacy of rising costs of protection and flood damage.”

Through lax planning rules and government subsidy, should we keep encouraging developers to develop and people to buy houses in areas known to be prone to natural disaster? Should we keep encouraging action that will almost certainly result in loss of life and billions in taxpayer expenses? Is the moral hazard created here any different from that of the banks we are all so quick to condemn?

Can we all be encouraged to become “too big to fail”?