Conference on Financial Crisis: Efficient Markets Let Failed Firms Fail

The primary role of government in the economy is to provide the “legal rules of the game,” said Eugene Fama, Robert R. McCormick Distinguished Service Professor of Finance. “It needs to make sure that markets and contracts work so that real activity can take place in the private sector in a more or less efficient way,” Fama said during a panel at the University of Chicago Conference on the Financial Crisis.

The conference, organized by the Money and Markets Workshop of the Council on Advanced Studies in Humanities and the Social Sciences, featured four panels of social science experts from London and throughout the United States. The daylong event was held at the Franke Institute for the Humanities at the Joseph Regenstein Library at the Hyde Park campus on April 10.

The problem with direct government involvement in economic activity is that the government is a political entity, not an economic entity, Fama said. “It’s going to behave in political ways,” he said. “We don’t expect efficiency in anything done by the government. Government activities face no survival threat. If they’re not doing well or are inefficient, they simply raise taxes or issue more debt to finance themselves.”

Whether or not the financial sector needs more regulation depends on how the government reacts to financial crisis, Fama said. “If the government allows financial institutions to fail, then no further regulation is necessary, because you’re letting people bear the costs and benefits of their actions,” he said. “But if it becomes the norm that the government will step in to bail out or back up failed institutions, that’s an entirely different game. Then regulation will be called for.”

Fama prefers the government stay out of the way. The Federal Deposit Insurance Corporation has the necessary mechanisms to deal with failed banks, he said. “You really don’t close these banks; you just reorganize them,” Fama said. “None of the activities of the banks on the asset side changes. The FDIC in principle comes in and draws a line on the liability side of the balance sheet and says, ‘Everything below the line is gone. Now we can go out and raise some new equity capital and start the bank over again.’”

Instead the FDIC has applied its power randomly in the current crisis, he said. Many large banks were shut down, but others have been inappropriately labeled “too big to fail,” Fama said.

“Once you knock out the debt overhang problem, once you get rid of the low-value debt, it turns out there are lots of people that want the deposits of these banks,” he said. “It’s a cheap way of expanding your deposit base. There’s nothing like expanding your deposits as a way of financing your activity.”

In such cases, the failed banks are reorganized as they are sold off in pieces or taken over entirely by other banks, Fama said. “This process is kind of seamless, because a bank is nothing but an accounting system,” he said. “You can merge these accounting systems pretty easily. Your account number doesn’t even change when your bank is acquired by another bank. Going forward, the system would be much more efficient if we simply let failed firms fail.”

                                                                                                                            — Phil Rockrohr