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Financial Planning > Behavioral Finance

Stiglitz: Big Means Vanilla

By Allison Bell

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Financial services companies that are too big to fail – and need to exist – should stick to selling conventional products, according to Joseph Stiglitz.

Stiglitz, a Columbia University economist who has won the Nobel Prize, made the argument that financial giants should stick to plain vanilla products today during a hearing of the congressional Joint Economic Committee.

Stiglitz, a Columbia University economist who has won the Nobel Prize, made the argument that financial giants should stick to plain vanilla products today during a hearing of the congressional Joint Economic Committee.

“With the bail-out of [American International Group Inc.], we have officially announced that any institution which is systemically significant will be bailed out,” Stiglitz said at the hearing, according to the written version of his testimony.

“Being too big to fail creates perverse incentives for excessive risk taking,” Stiglitz said. “The taxpayer bears the loss, while the bondholders, shareholders, and managers get the reward.”

The only solutions to the “too big to fail” problem are to break the companies up or to regulate them heavily, Stiglitz testified.

“The only justification for allowing these huge institutions to continue is that there are significant economies of scope or scale that otherwise would be lost,” Stiglitz argued.

So far, there is no evidence that combining activities such as insurance and investment banking in giant companies is responsible for any of the dynamism in the American economy, Stiglitz said.

“The touted synergies of bringing together various parts of the financial industry have been a phantasm,” Stiglitz said. “More apparent are the conflicts of interest.”

Giant banks that can show that their size is worthwhile and are also too big to fail “should be forced to return to the boring business of doing conventional banking,” Stiglitz said. “Too-big-to-fail insurance companies should face corresponding restrictions, e.g. they should be limited to selling conventional insurance products, with well defined actuarial risks.”

The restrictions could cut the returns of the giant banks and giant insurers, but that is as it should be, because companies should not be able to earn high returns by exposing U.S. taxpayers to risk, Stiglitz said.

Links to the written version of his testimony and other hearing documents are available here.

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