Wednesday, January 15, 2014

Definition of too big to fail is wrong

Recently I read that the regulators may be mandating that finance companies worth 100 billion and above will be classified as being too big to fail. Seriously, I wonder if the policy makers do know what they are talking about.

Let me give you a simple example. If I have a company that is worth 100 billion dollars with good operating cash flow and minimal or no debt, will this company be more dangerous than a company with a coverage ratio of less than 0.5?

The answer is pretty obvious. The issue with this too big to fail is not about the valuation of a company. It's about risk management. If the company takes big risk, they will definitely get into trouble. Furthermore, if they take big risk, they may also take great pains to conceal it under tons of documentation. Remember Enron?

The key is not in looking at the valuation, but to look from the risk management and compliance perspective. Finance companies, big or small, should have a strict oversight on the amount of risk they can take. For example, there may be a yearly review on the coverage ratio of the parent and all subsidiaries/associated companies for example. This review will look into both risk management and compliance with the finance regulations. Frequency may differ depending on how big the finance company is.

Putting a value to too big to fail is a wrong step in my opinion. A small company can also cause a lot of damage if too many wrong choices are made consecutively.

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