Reply #3: Alford is off base here...

[econoclast]

I like Alford, I really do. But I think that he is off base here.

While we agree that TBTF is bad, his Information Asymetry argument doesn't cut the mustard. He asserts that asymetric information results in inefficient markets and misallocation of capital. This is true. But the problem arises because some players have too little information, not because other players have too much!

Alford argues that the very scale and broad reach of TBTF institutions gives them access to better information:

"Large financial firms may also possess non issue specific information of a kind unavailable to other market participants by virtue of the size of their activities in market making, underwriting, issuing structured products, advising, prime brokering, or via knowledge of their counterparties or some combination. "

Following Alford's line of reasoning, the logical solution to the asymetry problem is to make smaller players BIGGER. If the thing that gives rise to better information is "the size of their activities in market making, underwriting, issuing structured products, advising, prime brokering, or via knowledge of their counterparties or some combination" then the way to get better information into the hands of those who currently don't have good information is to make them bigger!

If it is size that gives better information, then making TBTF institutions smaller reduces the amount of total information in the market. My Game Theory is a little rusty, but I'm hard pressed to think of how less information leads to more effecient markets and better allocations of capital.

Surely Alford doesn't want less information or more TBTF institutions. But that is exactly where his argument logically leads. For that reason it is a non-starter.

A better argument should be constructed around Nassim Taleb's example:

Why does NYC have, on average, such great food? Because bad restaurants don't last long!"