Column : Have we solved ‘too big to fail’?

Jan 21 2013, 01:03 IST
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SummaryThat is not my pessimistic verdict; it is the market’s. Prior to the crisis, the 29 largest global banks benefited from just over one notch of uplift from the ratings agencies due to expectations of state support.

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 in practice. Bail-in, whether of big banks, sovereigns or companies, 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—and historically has almost always done so, most notably in response to the present financial crisis. Next time may of course be different. But the market is sceptical. For example, in the US the Dodd-Frank Act on paper rules in future bail-in and rules out future bail-out. Yet market expectations of state support for US banks are higher today than before the crisis struck and are unchanged since Dodd-Frank became law. The time-consistency dilemma, at least in the eyes of markets, is as acute as ever.

(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, notably the ‘Volcker rule’ in the US, the ‘Vickers proposals’ in the UK and, most recently, the ‘Liikanen plans’ in Europe. While different in detail, each of these proposals shares a common objective: a degree of separation or segregation between investment and commercial banking activities.

In principle, these ringfencing 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 ringfence itself. The issue raised by some is whether, in practice, the ring-fence could prove permeable. Without care, today’s ring-fence could become tomorrow’s string vest.

If each of these initiatives is necessary but none is individually or collectively sufficient to tackle too-big-to-fail, what is to 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 more radical option, mooted recently by a number of commentators and policymakers, would be to place size limits on banks, either in relation to the

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