The European Union should start a debate on too-big-to-fail

by Morris Goldstein & Nicolas Véron

Vox
April 14, 2011

Are banks too big to fail? This column suggests now is the time for Europeans to ask this question. It argues that given the potential risks to systemic stability, there is a case for policy action even in the absence of analytical certainty.

The existence of too-big-to-fail financial institutions represents a three-fold policy challenge.

• First, such institutions exacerbate systemic risk by blunting incentives to manage risks prudently and by creating a massive contingent liability for governments that, in extreme cases, can threaten the latter’s own debt sustainability; Iceland in 2008-2009 and Ireland in 2010-2011 serve as dramatic, recent cases in point.
• Second, too-big-to-fail financial institutions distort competition. The 50 largest banks in 2009 benefitted from an average three-notch advantage in their credit ratings (BIS 2010) -- an advantage presumably related in part to the higher likelihood of official support at times of crisis.
• And third, the favoured treatment of too-big-to-fail institutions – often summarised as “socialisation of losses and privatisation of gains” – lowers public trust in the fairness of the system (Johnson 2009).

It is no wonder then that the too-big-to-fail issue is at the forefront of the debate on financial regulatory reform --as least as seen from Washington DC, London, and Zurich. Federal Reserve Chairman Ben Bernanke testified in September 2010 that “if the crisis has a single lesson, it is that the too big to fail problem must be solved” (Bernanke 2010). US Treasury Secretary Tim Geithner underscored that “the final area of reform (…) is perhaps the most important, establishing new rules to constrain risk-taking by – and leverage in – the largest global financial institutions (Geithner 2010). The Dodd-Frank Act of 2010 contains a host of provisions targeted at the regulation and supervision of systemically-important financial institutions, including enhanced risk-based capital, leverage, and liquidity standards and the requirement to prepare and maintain extensive rapid and orderly dissolution plans. In the UK, Bank of England Governor Mervyn King emphasised in a recent interview that “the concept of being too important to fail should have no place in a market economy” (King 2011). And later this month, the Vickers Commission is slated to give its recommendations on the banking industry, including its verdict on the merits of separating functions within the largest banks. Meanwhile, in the strongest approach to date to deal with the too-big-to-fail problem, a committee of experts appointed by the Swiss Federal Council (and including a representative from the Swiss National Bank) recommended that the total capital requirement for Switzerland’s two largest banks (UBS and Credit Suisse) be set at 19% of their risk-weighted assets, and that at least 10% of those assets must be held in the form of common equity (Committee of Experts 2010). If adopted, these capital requirements would be substantially more rigorous than the minimums recently agreed under Basel III (Goldstein 2011).

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