Graceful Failure and JPMorgan’s Loss

The biggest challenge facing regulators and politicians following the financial crisis is to engineer a regime that allows graceful failure for systemically important financial firms. Failure is, ironically, one of the great strengths of a market-based economy – the creative destruction of Schumpeter. When firms can fail without disastrous social consequences (at least not disastrous for the wider world beyond the owners, investors, workers) then mistakes and bad luck have lower social costs. The real importance of JPMorgan’s recently-announced loss is not the loss – not a seriously damaging event in itself – but the reminder that had it been a serious loss JPMorgan could not have gone out of business without putting the world at risk.

Ironic as it is, a vibrant and functioning economy needs mistakes and failures. Firms need to take risk, need to make mistakes. Risk, mistakes, and bad luck are part of life and without them we would never have the obverse, which is opportunity and success. Most mistakes and most bad luck, in business as in life, are not fatal. Mostly we can compensate, recover from, correct and learn from mistakes. Sometimes, however, mistakes do prove fatal. Some risk and some level of mistakes are necessary in business because without taking the risks we would never have the successes. The key is to find a balance between too much and too little risk. Indeed, the philosopher Nicholos Rescher in his delightful book Luck talks about risk management as “managing the direction of and the extent of exposure to risk, and adjusting our risk-taking behavior in a sensible way over the overcautious-to-heedless spectrum.” (p 187).

In this respect the story in the Financial Times, US and UK eye reaction to bank failure is good news. Regulators are working on “resolution plans” that would see authorities take over a firm and force shareholders and bondholders to take losses, while keeping critical operations open.

I am not optimistic that regulators will be successful, because it is such a difficult problem, but it is the most important piece, maybe the only important piece, of any new regulatory regime. When bank shareholders and bondholders know that their investments are at risk when a firm misbehaves, those investors will monitor and discipline the firm in a way that regulators simply cannot.

About Thomas Coleman

Thomas S. Coleman is Senior Advisor at the Becker Friedman Institute for Research in Economics and Adjunct Professor of Finance at the Booth School of Business at the University of Chicago. Prior to returning to academia, Mr. Coleman worked in the finance industry for more than twenty years with considerable experience in trading, risk management, and quantitative modeling. Mr. Coleman earned a PhD in economics from the University of Chicago and a BA in physics from Harvard College.
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