How « Too Big to Fail » Thinking Trumps Competition and Increases Risk of Banking Crisis

Published by Philippe Herlin | Apr 10, 2014 | Articles

We are aware of the problems of « Too Big to Fail » banks : They are so big that, if they were to fail, it would cause such economic havoc that they can rest assured to be bailed out by the State. And they’re taking advantage of this situation by taking on even more risk! This perverse effect, this « moral hazard », makes for a much less stable financial system, more exposed to a crisis.

In the third chapter of its last « Report on Financial Stability » of April 2014, the IMF writes about this phenomenon and tries to measure it. One shouldn’t consider that this Too Big to Fail principle would only have concrete effects the day one of those banks would declare bankruptcy. As the IMF very aptly explains, those banks benefit permanently from that principle : This implicit guarantee lets them borrow at lower interest rates, raise more money from clients reassured by this State guarantee, and chase yields that are riskier, but more profitable.

The IMF thus estimates that this State guarantee is equivalent to an implicit grant to those banks of 300 billion euros in the Eurozone, 110 billion in the United Kingdom, 110 billion in Japan, and 70 billion in the United States. These numbers are for 2012. Of course, those are only estimations, and they could be challenged, but their high level shows that those large banks have a considerable unfair advantage over other financial institutions.

Consequently, the whole free market competition game is rigged. Smaller banks, for their part, have to take into account bankruptcy risks and act more prudently, less aggressively, with less leverage, having less risky positions on the markets. Having to do so, they are less competitive than the TBTFs and lose clients who opt to go with those... which, at the end, brings yet more global instability to the financial system.

What makes this worse is that the 2008 crisis exacerbated this phenomenon. Several large banks were swallowed by other ones (Bear Stearns by JP Morgan, Fortis by BNP-Paribas, etc.), and their number was reduced. Paradoxically, the failure of Lehman Brothers, abandonned by the Fed and the government (the one exception to the TBTF rule!), provoked such a market crash that the belief that States will do whatever it takes to prevent this from happening in the future was much reinforced.

To fight this perverse effect, the IMF suggests the obligation for the banks to strengthen their liquid reserves and for the shareholders and creditors to absorb losses in case of failure. We could add to that the necessity of punishing CEOs who act wrongly, and of returning to a separation between deposit banking activities and market activities. The IMF states that governments have a long road ahead to « protect tax payers (and I would add the savers), insure equal opportunities and promote financial stability. » Hear, hear!

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Philippe Herlin  Finance Researcher / Member of the Goldbroker Editorial Team


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