Is It Possible To Separate Big Banks From Too Big To Fail?

Is It Possible To Separate Big Banks From Too Big To Fail?

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My colleague Frances Coppola rightly notes that big banks don’t fail very often, and that most of the financial crises of the past century were sparked by small, unregulated banks: “[Big banks] are more resilient and less likely to fail than other banks, because their balance sheets are sufficiently big and diversified to absorb shocks.”

Frances correctly notes that a big financial danger in the future may come from small and unregulated lenders — including peer-to-peer lenders, and payday lenders which in Britain are not regulated by the Prudential Regulatory Authority — failing simultaneously. It is often the case in regulation that regulators (and probably politicians, economists, etc) over-focus on fighting the last war, endlessly stress-testing and fretting over large banks’ leverage ratios while largely ignoring the dangers posed by smaller relatively unregulated lenders is a strong possibility.

And Frances does not dismiss the potential for problems with big banks noting: “I accept completely that the presence in a country of banks whose balance sheets dwarf GDP can present a considerable risk to its economy, as Iceland and Cyprus have amply demonstrated.”

And yet I am not entirely convinced that it is possible to separate — as Frances tries to — the existence of big banks from the problems of Too Big To Fail, and the widespread damage that can be done to an economy by the collapse of a large bank. The extensiveness of a large bank’s balance sheet is a mixed bag. While a large balance sheet may offer diversification that may allow a large bank to absorb a shock, if a very large shock pushes a large bank into default that same resilience that insulates large banks from shocks turns on its head — a bigger balance sheet in life, means bigger and more widely-distributed defaults in death. 

So while large bank failures tend to be far rarer than small bank failures — meaning that most of the time big banks insulate the system from shocks — they also tend to be vastly more devastating. So large banks are a systemic tail risk to a financial system. And this danger stems directly from the size and interconnectivity of their balance sheets. 

But the goal should not be to eliminate large banks. Most of the time their size is a boon, and a source of systemic stability. And I think a regulatory regime that went around chopping up banks based on an arbitrary size-based rule might do more harm than good. At the very least, it would be collective punishment. No, the goal should be to ameliorate the problems with big banks as and when they occur. It is possible to mitigate some of these problems via the provision of central bank liquidity guarantees in the context of a bank run. With enough liquidity provision, it should be possible to prevent a default cascade even in the context of the failure of a very large bank. This is especially true if regulators are clear about the criteria for liquidity provision, to avoid the confusion that occurred during and after the Lehman bust, when the market assumed a highly-interconnected bank like Lehman would be bailed out and it wasn't. 

Unfortunately, whether the central bank and the broader financial and political systems are willing to provide such facilities is uncertain; a central bank mandated with minimising inflation may be uneasy and unwilling to make available unlimited liquidity facilities even in the context of freefall. And many of a liquidationist bent may see such provisions as anti-capitalistic or against the ideal of a free market. This sometimes means that relatively large banks may be allowed by authorities to fail in an uncontrolled way.

So this brings me to the awkward conclusion that while big banks may sometimes become problematic and a danger to the financial system, there is not really much that can realistically be done about it beyond providing liquidity in case a large bank does collapse. This is a worrying thought — because it means that future crises involving the uncontrolled collapse of a large bank may very well occur. But the next crisis (like the vast majority of crises in the last century) will emerge from other sectors, especially smaller unregulated lenders, perhaps once again those specialising in lending to the relatively uncreditworthy like payday lenders. 

The widespread habit of seeking out the next crisis in the echoes of Too Big To Fail, is almost certainly a case of mistakenly fighting the last crisis, even though the last crisis was as much about the laxly regulated shadow banks as it was about Too Big To Fail. This is a crude mistake.


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