The world must learn to deal with the reality of failure


Last week, the Financial Stability Board identified nine international insurance companies as GSifis. For those uninitiated in the acronyms beloved of the regulatory community, a GSifi is a global systemically important financial institution. Finding GSifis in the insurance sector is a solution in search of a problem. Having invented the concept of GSifi to describe too-big-to-fail banks, the world’s financial regulators are on the hunt for other businesses which can be treated in a similar way.

As the modern business world becomes more interdependent, there are more and more corporations whose failure would have a substantial impact on many others, a theme extensively developed by Barry Lynn in his book Cornered.

Globalisation means that business may be domestically concentrated even if internationally competitive. Outsourcing means that supply chains are longer, more complex, and often shared by different companies in the same industry. While once the failure of General Motors would have been an unequivocal benefit to Ford, these competitors are today interdependent in a way Alfred Sloan or Henry Ford could not have imagined. The impact of the tsunami on Japanese industry showed how just-in-time inventory management left many companies vulnerable when deliveries were just not in time, even if their operations had not been directly affected by the disaster.

More companies in different businesses are now, in this sense, systemically important. But insurers do not come close to the top of the list. The payment system operated by banks is a key utility, like the electricity or communications network: even the briefest interruption to supply causes chaos. Disruption to the provision of food or fuel brings both business and personal life to a halt within a few days. But there is little comparable urgency about the availability of insurance; when has there been an agitated queue outside an insurance broker or panic buying of insurance? And compared with the extended supply chains necessary to put food on our tables, fuel in the tanks of our cars, or enable the cars to be assembled in the first place, the supply chain for insurance seems reassuringly uncomplicated.

We need to ensure that large businesses can be resolved when they fail with minimal damage to the rest of the economy. This has been best achieved in parts of the utility sector, where measures exist to secure continued provision of the function alongside dissolution of the failed corporate entity.

The fundamental principle must be that when a business fails, the shareholders should be wiped out, senior managers should be dismissed and there should be an appropriate distribution of the assets of the collapsed entity among the various creditors. That distribution must incorporate claims of equity and efficiency, and both considerations imply that those who might have been expected to have knowledge of the parlous state of the business should take the bulk of the negative consequences of its failure.

Insurance does raise a particular problem here; a socially managed compensation scheme, which ensures that people who have outstanding claims when their insurer goes down are dealt with fairly, is essential. Most developed countries now have such provision.

What is needed is a system of resolution for large corporations which operate internationally regardless of their industry. That regime must achieve an appropriate balance between the claims of creditors and the needs of the global economy. What is not only not needed, but should be strenuously resisted, is the development of a system of regulatory supervision of large corporations which purports to reduce or eliminate the probability of their commercial failure.

Regulators have neither the competence nor political authority to implement such a system, and their attempt to do so will have two outcomes: the ossification of industries around incumbents, and the repeated use of public funds to support struggling companies.

In no industries except financial services do regulators even attempt to take a view of the appropriate business strategy for the companies they monitor. There are good reasons for this, and anyone who has forgotten what they are should be reminded of the effects such a regime had on the economic performance of east Germany.

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