Have we solved 'too big to fail'?

By Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

The Subprime Crisis became the global crisis when one too-big-to-fail bank was allowed to fail. Andrew Haldane argues in a recent VOXEU communique (Jan. 17^th) that too-big-to-fail is far from gone despite reform efforts. Further analytical work, weighing the costs and benefits of different structural reform proposals, would help keep memories fresh and policies on the right track. No!

That is not a pessimistic verdict; it is the markets. Prior to the crisis, the 29 largest global banks benefitted from just over one notch of uplift from the ratings agencies due to expectations of state support. Today, this is now around three notches of implied support. Expectations of state support have risen threefold since the crisis began.

This translates into a large implicit subsidy for large banks in the form of lower funding costs and higher profits. Prior to 2007, this amounted to tens of billions of dollars each year. Today, it is hundreds of billions. In other words, the regulatory response to the crisis has not plugged the 'too-big-to-fail' sink.

The regulation to quell the too-big-to-fail reform effort falls into roughly three categories:

(a) Systemic surcharges: of additional capital levied on the world’s largest banks according to their size and connectivity. The highest surcharge was set at 2.5% of capital.  However, a charge levied at this rate would leave the majority of the systemic externalities associated with large banks untouched. The reduction in default probabilities associated with lowering leverage by a percentage point or two would not offset the higher system-wide loss-given-default associated with the world’s largest banks.

(b) Resolution regimes: In principle, orderly resolution regimes for banks could lower the collateral costs of a big bank defaulting, thereby tackling at source these systemic externalities. A key component of these plans is the ability to impose losses on private creditors – so-called 'bail-in' – rather than have those losses borne by taxpayers.

As with systemic surcharges, the issue here is not to so much the bail-in principle, but its application. Bail-in, faces an acute time-consistency problem. Policymakers face a trade-off between placing losses on a narrow set of tax-payers today (bail-in) or spreading that risk across a wider set of tax-payers today and tomorrow (bail-out). A risk-averse, tax-smoothing government may tend towards the latter path.

(c) Structural reform: One way of lessening that dilemma may be to act on the scale and structure of banking directly. Several recent regulatory reform initiatives have sought to do just that, where each of these proposals shares a common objective: a degree of separation or segregation between investment and commercial banking activities.

These ring fencing initiatives confer both ex-post (improved resolution) and ex-ante (improved risk management) benefits. Because they act on banking structure, they have a greater chance of proving time-consistent. While this is a clear step forward, those benefits are only as credible as the ring fence itself.

If these initiatives are necessary but none are sufficient to tackle too-big-to-fail, what can be done? One solution might lie in strengthening these proposals. For example, re-sizing the capital surcharge, perhaps in line with quantitative estimates of the 'optimal' capital ratio, would be one option for bearing down further on systemic externalities.  Another option would be to place size limits on banks, either in relation to the financial system or relative to GDP.

Proposals of this type face two sets of criticism. The first, practical issue is how to calibrate an appropriate limit. Recent research on the link between and financial depth and growth provides a way into this question. The second, empirical issue is whether size limits would erode the economies of scale and scope which might otherwise be associated with big banks.  Recent research suggests economies of scale for banks with balance sheets in excess of $1 trillion.

This evidence needs to be interpreted cautiously, because it fails to recognize the implicit subsidies associated with too-big-to-fail. They lower funding costs and boost measured valued-added for the big banks. Consequently, the implicit subsidy would show up as economies of scale. Bank of England research indicates, once those subsidies are accounted for, evidence of scale economies for banks with assets in excess of $100 billion tends to disappear.  There may even be evidence of scale diseconomies, perhaps consistent with big banks being 'too big to manage'.

Too-big-to-fail is far from gone. Further analytical work, weighing the costs and benefits of different structural reform proposals, would help keep memories fresh and policies on the right track.  It will continue to be a challenging environment for risk management

www.voxeu.org/article/have-we-solved-too-big-fail