The subprime crisis—and the subsequent global financial crisis—was set in motion when a bank considered too big to fail bank was actually allowed to fail and go bankrupt. Despite five years of reform efforts, Too-Big-To-Fail Syndrome is far from gone. More research work, including analyzing the costs and benefits of various structural reforms schemes, would help authorities put the world’s financial system back on the right track.
Prior to the subprime crisis, twenty-nine of the largest global banks saw their ratings raised just over one notch by credit rating agencies because markets expected that they would be able to get state support. Today, those same financial behemoths benefit from implicit support of nearly three notches by credit rating agencies. Expectations of public funds support have tripled since the beginning of the crisis.
In real terms this amounts to an enormous subsidy to the world’s largest banks at artificially low funding costs and ensuring greater profits. Before the financial crisis hit the world economy, tens of billions of dollars were pumped into big banks’ coffers on an annual basis. Today, it amounts to hundreds of billions. In other words, if we are to believe the financial market’s expectations, the regulations put in place by governments and international institutions have not prevented “too-big-to-fail” syndrome.
The financial industry never misses an occasion to warn against oppressive regulations of world’s largest banks. What we know for sure, though, is that regulations to subdue the "too-big-to-fail" syndrome have come in from all sides, and came rather quickly after the start of the crisis. Three types of reforms are observed.
The first type of reforms consists of overloading additional capital collected from the world’s biggest banks based on their size and connectivity (the way in which corporations and banks communicate electronically). Conceptually, this tax on systemic externalities is built on strong economic foundations and, thankfully, has been incorporated into sound public policy. Last year, the Financial Stability Board (FSB)—an international agency established in 2009 after the G20 London summit and based in Basel, Switzerland—d agreed to use a sliding scale approach in setting up systemic surcharges for the world’s largest banks. The highest capital surcharge was established at 2.5 percent.
This is the heart of the problem. Based on the estimates of Andrew G. Haldane, Executive Director at the Bank of England, this tax rate is insufficient to affect the behavior of the world’s largest banks. The probability of default with a more or less 2 percent tax is plausibly reduced, especially if the biggest banks are faced with an external shock. However, this amplified absorption capacity will likely entail riskier behavior by the largest banks; this does not constitute in itself a reinforced protection of financial systems. The capital surcharge is simply being levied at rates that are not high enough to change banks’ sometimes dangerous behavior.
The second type of reforms is to modify the resolution regimes for financial institutions, banks in particular. Effective resolution regimes for banks reduce the cost of such an operation and the cost for taxpayers. They also should treat the root cause of systemic risks. Significant progress has been made in public policy on this front, as over the last 18 months the Financial Stablity Board has published (with the G20 approval) a number of legislative proposals—for example, Key Attributes for Effective Resolution Regimes. A key “attribute” of these proposals is the so-called “bail-in,” i.e., the ability to impose losses on private creditors and shareholders rather than to ask taxpayer to incur these losses.
The problem with these proposals is not so much the principle but, as with systemic surcharges, its application in practice. Whether it deals with large banks or public debt, a good resolution regime for a “bail-in” is liable to a serious time-consistency problem. Policymakers must choose between, on the one hand, placing losses on a small group of taxpayers—shareholders and bondholders—today or, on the other hand, spreading out these losses across a wider number of taxpayers now and into the future—a “bail-out.”
In general, risk-averse Western governments tend to adopt the second solution (bail-outs). Throughout history, they have almost always used this strategy, particularly in response to financial crisis similar to the current one. A bailout—or spreading the losses—can hold off deadlines and avoids a direct conflict with influential groups. However, the market is usually skeptical of politically based rational choices. For example, the Dodd–Frank Wall Street Reform and Consumer Protection Act, passed by the U.S. Congress on May 20, 2010 and the largest financial regulation overhaul since the 1930s, on paper set out the obligation to use bail-ins in the future and rules out future public bail-out for incompetent or irresponsible investors and market speculators. However, market expectations of state support for U.S. banks are, ironically, higher today than they were before the 2008 crisis, despite the Dodd-Frank Act. In the eyes of the markets, the time-consistency problem is now more acute than ever.
Finally, "too-big-to-fail" syndrome could be overcome with structural reforms. One way of mitigating the time-consistency dilemma may be to directly alter the scale and structure of banking itself. The “Volcker rule” in the United States, for instance, has sought to restrict U.S. banks from making certain kinds of speculative investments which are harmful to their customers. In the UK, the “Vickers proposals” try to do the same, as well as the “Liikanen plans” more recently in Europe. Although they differ in details, each of these proposals shares a common goal: to achieve a degree of separation between investment and commercial banking activities.
In principle, these ring-fencing initiatives generate benefits both ex-post (better resolution regimes or bankruptcy laws) and ex-ante (improved risk management). As they affect the banking structure, their chances of withstanding the test of time are increased. While this is a real step forward, these benefits will only be credible if the separation between investment and commercial banking activities is maintained in the long term. Indeed, many wonder if, in practice, the ring-fencing could prove porous over time. Without constant monitoring, the ring-fencing of today has the potential to become a leaking umbrella tomorrow.
What if each of these initiatives is necessary but none is individually or collectively sufficient to address the “too-big-to-fail” syndrome? One solution might be to consolidate these proposals. For example, one might consider a re-sizing of the capital surcharge, possibly on the basis of quantitative estimates of the optimal capital ratio for bank, as David Miles, former Chief UK Economist of Morgan Stanley, and Jing Yang, senior economist at the Bank for International settlements, argued in an the Economic Journal in 2012.
A more radical approach would be to simply set a ceiling for the size of banks, either as a proportion of the financial system as a whole or, more reasonably, relative to GDP, as suggested by Daniel Tarullo, FED governor, and Thomas Hoenig, Director of the Federal Deposit Insurance Corporation. Proposals of this type, mooted recently by a number of commentators and policymakers, are generally criticized on two counts.
The first criticism pertains to a practical matter: How to calibrate an appropriate limit? A recent IMF working paper, authored by Jean-Louis Arcand, Enrico Berkes, and Ugo Panizza, on the link between financial depth and economic growth sheds light on the question. It suggests that a negative impact on GDP starts to kick in at a certain level of the private-credit-to-GDP ratio. Productivity growth is also affected negatively. By carefully analyzing this aggregate threshold and the most appropriate concentration level in the banking industry, a threshold could be derived for each financial institution.
The second criticism is empirical: Would limiting banks’ size make them less efficient? Can smaller banks achieve economies of scale? Until recently, the empirical literature suggested that the efficiency of banks starts to decline at a relatively small size. But a number of studies published recently have debunked these findings. David C. Wheelock and Paul Wilson (“Do Large Banks have Lower Costs? New Estimates of Returns to Scale for U.S. Banks,” Journal of Money, Credit, and Banking, 2012), for example, found that some banks with balance sheets over $1 trillion were still able to achieve economies of scale.
However, these results should be interpreted with caution, especially because they do not take into account the implicit subsidies associated with “too-big-to-fail,” as we have described above. These subsidies tend to bring down big banks’ financing costs and to inflate their value. In other words, the implicit subsidy increases the threshold at which banks’ efficiency begins declining. A study by the Bank of England has recently shown that banks with assets upwards of $100 billion see their economies of scale disappear once implicit subsidies are taken into account. In fact, it seems that banks’ efficiency declines fairly rapidly with size because large banks are also “too big to manage.”
The “too-big-to-fail” syndrome still prevails and this must be continuously kept in mind, for regulators and investors alike. Additional research on this crucial topic would do much in helping to refresh memories once in a while and keep banking industry reforms on track.
Richard Rousseau is Associate Professor and Chairman of the Department of Political Science and International Relations at Khazar University in Baku, Azerbaijan. His research, teaching, and advisory interests include Russian politics, Eurasian geopolitics, international political economy, and globalization.
This article was originally published in the special annual G8 Summit 2013 edition and The Official ICC G20 Advisory Group Publication. Published with permission.
Photo: The "Wall Street Bull" in New York City. By Christopher Chan (cc).
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Too-Big-To-Fail Syndrome
August 22, 2013
The subprime crisis—and the subsequent global financial crisis—was set in motion when a bank considered too big to fail bank was actually allowed to fail and go bankrupt. Despite five years of reform efforts, Too-Big-To-Fail Syndrome is far from gone. More research work, including analyzing the costs and benefits of various structural reforms schemes, would help authorities put the world’s financial system back on the right track.
Prior to the subprime crisis, twenty-nine of the largest global banks saw their ratings raised just over one notch by credit rating agencies because markets expected that they would be able to get state support. Today, those same financial behemoths benefit from implicit support of nearly three notches by credit rating agencies. Expectations of public funds support have tripled since the beginning of the crisis.
In real terms this amounts to an enormous subsidy to the world’s largest banks at artificially low funding costs and ensuring greater profits. Before the financial crisis hit the world economy, tens of billions of dollars were pumped into big banks’ coffers on an annual basis. Today, it amounts to hundreds of billions. In other words, if we are to believe the financial market’s expectations, the regulations put in place by governments and international institutions have not prevented “too-big-to-fail” syndrome.
The financial industry never misses an occasion to warn against oppressive regulations of world’s largest banks. What we know for sure, though, is that regulations to subdue the "too-big-to-fail" syndrome have come in from all sides, and came rather quickly after the start of the crisis. Three types of reforms are observed.
The first type of reforms consists of overloading additional capital collected from the world’s biggest banks based on their size and connectivity (the way in which corporations and banks communicate electronically). Conceptually, this tax on systemic externalities is built on strong economic foundations and, thankfully, has been incorporated into sound public policy. Last year, the Financial Stability Board (FSB)—an international agency established in 2009 after the G20 London summit and based in Basel, Switzerland—d agreed to use a sliding scale approach in setting up systemic surcharges for the world’s largest banks. The highest capital surcharge was established at 2.5 percent.
This is the heart of the problem. Based on the estimates of Andrew G. Haldane, Executive Director at the Bank of England, this tax rate is insufficient to affect the behavior of the world’s largest banks. The probability of default with a more or less 2 percent tax is plausibly reduced, especially if the biggest banks are faced with an external shock. However, this amplified absorption capacity will likely entail riskier behavior by the largest banks; this does not constitute in itself a reinforced protection of financial systems. The capital surcharge is simply being levied at rates that are not high enough to change banks’ sometimes dangerous behavior.
The second type of reforms is to modify the resolution regimes for financial institutions, banks in particular. Effective resolution regimes for banks reduce the cost of such an operation and the cost for taxpayers. They also should treat the root cause of systemic risks. Significant progress has been made in public policy on this front, as over the last 18 months the Financial Stablity Board has published (with the G20 approval) a number of legislative proposals—for example, Key Attributes for Effective Resolution Regimes. A key “attribute” of these proposals is the so-called “bail-in,” i.e., the ability to impose losses on private creditors and shareholders rather than to ask taxpayer to incur these losses.
The problem with these proposals is not so much the principle but, as with systemic surcharges, its application in practice. Whether it deals with large banks or public debt, a good resolution regime for a “bail-in” is liable to a serious time-consistency problem. Policymakers must choose between, on the one hand, placing losses on a small group of taxpayers—shareholders and bondholders—today or, on the other hand, spreading out these losses across a wider number of taxpayers now and into the future—a “bail-out.”
In general, risk-averse Western governments tend to adopt the second solution (bail-outs). Throughout history, they have almost always used this strategy, particularly in response to financial crisis similar to the current one. A bailout—or spreading the losses—can hold off deadlines and avoids a direct conflict with influential groups. However, the market is usually skeptical of politically based rational choices. For example, the Dodd–Frank Wall Street Reform and Consumer Protection Act, passed by the U.S. Congress on May 20, 2010 and the largest financial regulation overhaul since the 1930s, on paper set out the obligation to use bail-ins in the future and rules out future public bail-out for incompetent or irresponsible investors and market speculators. However, market expectations of state support for U.S. banks are, ironically, higher today than they were before the 2008 crisis, despite the Dodd-Frank Act. In the eyes of the markets, the time-consistency problem is now more acute than ever.
Finally, "too-big-to-fail" syndrome could be overcome with structural reforms. One way of mitigating the time-consistency dilemma may be to directly alter the scale and structure of banking itself. The “Volcker rule” in the United States, for instance, has sought to restrict U.S. banks from making certain kinds of speculative investments which are harmful to their customers. In the UK, the “Vickers proposals” try to do the same, as well as the “Liikanen plans” more recently in Europe. Although they differ in details, each of these proposals shares a common goal: to achieve a degree of separation between investment and commercial banking activities.
In principle, these ring-fencing initiatives generate benefits both ex-post (better resolution regimes or bankruptcy laws) and ex-ante (improved risk management). As they affect the banking structure, their chances of withstanding the test of time are increased. While this is a real step forward, these benefits will only be credible if the separation between investment and commercial banking activities is maintained in the long term. Indeed, many wonder if, in practice, the ring-fencing could prove porous over time. Without constant monitoring, the ring-fencing of today has the potential to become a leaking umbrella tomorrow.
What if each of these initiatives is necessary but none is individually or collectively sufficient to address the “too-big-to-fail” syndrome? One solution might be to consolidate these proposals. For example, one might consider a re-sizing of the capital surcharge, possibly on the basis of quantitative estimates of the optimal capital ratio for bank, as David Miles, former Chief UK Economist of Morgan Stanley, and Jing Yang, senior economist at the Bank for International settlements, argued in an the Economic Journal in 2012.
A more radical approach would be to simply set a ceiling for the size of banks, either as a proportion of the financial system as a whole or, more reasonably, relative to GDP, as suggested by Daniel Tarullo, FED governor, and Thomas Hoenig, Director of the Federal Deposit Insurance Corporation. Proposals of this type, mooted recently by a number of commentators and policymakers, are generally criticized on two counts.
The first criticism pertains to a practical matter: How to calibrate an appropriate limit? A recent IMF working paper, authored by Jean-Louis Arcand, Enrico Berkes, and Ugo Panizza, on the link between financial depth and economic growth sheds light on the question. It suggests that a negative impact on GDP starts to kick in at a certain level of the private-credit-to-GDP ratio. Productivity growth is also affected negatively. By carefully analyzing this aggregate threshold and the most appropriate concentration level in the banking industry, a threshold could be derived for each financial institution.
The second criticism is empirical: Would limiting banks’ size make them less efficient? Can smaller banks achieve economies of scale? Until recently, the empirical literature suggested that the efficiency of banks starts to decline at a relatively small size. But a number of studies published recently have debunked these findings. David C. Wheelock and Paul Wilson (“Do Large Banks have Lower Costs? New Estimates of Returns to Scale for U.S. Banks,” Journal of Money, Credit, and Banking, 2012), for example, found that some banks with balance sheets over $1 trillion were still able to achieve economies of scale.
However, these results should be interpreted with caution, especially because they do not take into account the implicit subsidies associated with “too-big-to-fail,” as we have described above. These subsidies tend to bring down big banks’ financing costs and to inflate their value. In other words, the implicit subsidy increases the threshold at which banks’ efficiency begins declining. A study by the Bank of England has recently shown that banks with assets upwards of $100 billion see their economies of scale disappear once implicit subsidies are taken into account. In fact, it seems that banks’ efficiency declines fairly rapidly with size because large banks are also “too big to manage.”
The “too-big-to-fail” syndrome still prevails and this must be continuously kept in mind, for regulators and investors alike. Additional research on this crucial topic would do much in helping to refresh memories once in a while and keep banking industry reforms on track.
Richard Rousseau is Associate Professor and Chairman of the Department of Political Science and International Relations at Khazar University in Baku, Azerbaijan. His research, teaching, and advisory interests include Russian politics, Eurasian geopolitics, international political economy, and globalization.
This article was originally published in the special annual G8 Summit 2013 edition and The Official ICC G20 Advisory Group Publication. Published with permission.
Photo: The "Wall Street Bull" in New York City. By Christopher Chan (cc).
