Econ Grapher

Codify Too Big To Fail

In banking Too Big To Fail (TBTF) has become an implicit policy i.e. when a bank that is deemed to be too big, or too significant, to fail it is provided with government support of some manner in order to prevent its demise. The premise is: were it not for government intervention the bank would fail (whichever form that takes), and the cost of failure would in essence be the impact on the financial system.

The costs could come in the form of mild to extreme disruption of the payment system, and/or realization of counterparty risks (derivatives, interbank loans, FX transactions, etc). There would also be wider costs from the contagion effects e.g. market panic causes asset price falls and loss of liquidity, possibly filtering through to a bank panic.

In short you risk serious damage to the payment system and the banking system, as well as the wider financial and capital markets. This would then logically flow through to the real economy as credit and liquidity dries up and prevents businesses from being able to rollover loans or secure working capital finance. Also the disruption of the payments system would have obvious detrimental effects on the real economy.

Thus in order to avoid this, regulators/governments will generally opt for assistance/intervention to prevent, or as some central banks suggest “manage”, the failure of the institution in question. The consequences of this are:
1. The financial costs of supporting/unwinding/nationalizing the institution; and
2. The impact on the behaviour of participants in the sector.

The second point is arguably the more costly, it is also known as moral hazard; which roughly means if you know you have an implicit government guarantee on the downside then you’re basically operating a giant complex call option. Or in other words you don’t need to worry too much about failing, thus you can engage in more risky activity than you otherwise would.

I learnt about the above well before the GFC when I was studying for a masters degree, but the pernicious and pervasive realities of the banking crisis has spurred me to think more on this topic.

This is a thought starter and ultimately a suggestion to policy makers.

Instead of holding an implicit TBTF policy, governments should adopt an explicit policy and recognize the costs.

The US government made some steps towards this when Obama proposed charging banks a 0.15% fee on total liabilities (less deposits) over the next 10 years as a means of paying back the government for the bailout.

I suggest taking this a step further, and recognize that when a large financial institution fails the impact on the financial system and real economy can be little short of catastrophic (e.g. http://www.imf.org/external/pubs/ft/weo/2009/02/pdf/c4.pdf ).

So make it absolutely clear that stability of the financial system will not be compromised and banks beyond a certain size will be charged a risk premium by the government that goes towards a fund for “managing” failures of TBTF institutions.

Another alternative is to change the capital ratio rules such that it steps up based on the size of the institution e.g. a small bank may have a minimum capital ratio of 8%, whereas a large bank may have a minimum capital ratio of 10%+. Note: the capital ratio is the ratio of equity to total assets and is one of the key metrics in the Basel rules.

The options are limitless, the key is to intervene so that either moral hazard is adjusted through mandating risk limits (e.g. capital ratios), or that the direct costs of bailout are pre-paid as part of a cost of business for those in the sector.

On the surface such ideas are likely to be less burdensome on the real economy than simply letting a large bank fail to deliver the message about moral hazard – the impact on the real economy is just too great; you only need to look at the collapse of Lehmans to see how bad things can get.

Another argument is to simply chop up banks that get too big or restrict activities that banks can engage in (e.g. Glass Steagall). This is also valid, but there are arguments for size benefits – but this is another argument altogether.

In summary, out of the options of:
1. Charge a premium for an explicit TBTF policy and/or install risk limits that mitigate moral hazard; or
2. Let them fail (no bank is TBTF, costs of financial system damage and economic recession/depression are absorbed by all, but at least there’s no more moral hazard)
3. Break them up (cut TBTF institutions down to size, at the risk of limiting any economies of scale and other market distortions)
4. Restrict activities (keep banks boring and simple, but this doesn’t prevent incidences of Long Term Capital Management’s)

It seems that no.1 is an interesting and viable alternative to the problem of TBTF institutions. However it must be acknowledged that none of these solutions are perfect, but it seems this is the least imperfect. Also this list is –not- exhaustive, I’m sure anyone could think of many more ideas. And ultimately if the first option was taken it would need to be implemented in a way that would allow swift yet transparent circumvention of any loopholes or engineering that the banks might engage in to avoid it.

So there you go, for what it’s worth, a potential solution to the TBTF problem. I now invite you to tear my work apart.


Oh and I realize I didn't put any graphs in as is characteristic of my usual articles so here's a piece on US bank lending.



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