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April 15, 2011

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

This column co-authored with Morris Goldstein was published online by Vox, and also in Dutch by NRC Handelsblad.

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).

It is all the more remarkable then that the too-big-to-fail problem is barely present in substantial financial policy debates and initiatives in most Continental European countries and at EU level, including the European Commission. These jurisdictions have tended to favour the application of uniform regulations to financial institutions irrespective of size and systemic importance, and have been generally reported as arguing against specific policies targeted at systemically-important financial institutions in international bodies such as the Basel Committee on Banking Supervision and the Financial Stability Board.

In a working paper that specifically analyses the transatlantic and intra-European variations of the too-big-to-fail debate (or absence thereof); we identify four broad reasons for this contrast (Goldstein and Véron 2011):

  • First and foremost, the much higher degree of concentration of banking markets makes the too-big-to-fail problem more acute but also intrinsically more intractable in virtually all EU countries than it is in the US, which may explain a strong reluctance to consider financial reform through the too-big-to-fail prism in the first place; see Figure 1.

Figure 1. Aggregate assets to GDP of top three banks in selected countries (%)

Graph
Source: Bank for International Settlements

The higher assets-to-GDP ratios observed in Europe are mainly due to high banking sector concentration, significant international expansion of some major banks, and business models that lead banks to retain many assets on their balance sheet. Differences in accounting standards also play a role, but only to a much smaller extent.

Of course, a large part of this transatlantic difference would disappear if the systemic importance of Europe’s largest banks could be assessed against the size of the entire European economy, rather than national GDP. Indeed, the ratios of consolidated assets to European GDP for Europe’s largest banks are similar to the ones that can be observed in the US, or actually smaller when corrected for differences in accounting standards. Unfortunately, this is not the correct scale of analysis as long as no EU-wide policy framework exists for bank crisis management and resolution. Such a framework has been advocated and discussed by the IMF and others (see Cihak and Decressin 2007; Fonteyne and al 2010; Véron 2007; Wall et al. 2011) but has not achieved political consensus in the EU so far. Policy proposals are expected from the European Commission this year, but they are unlikely to result in more than incremental progress from this perspective (European Commission 2011).

  • Second, most European countries have displayed a general reluctance to let banks fail irrespective of their size, so that the moral hazard problem is not confined to the largest institutions. An example of this (early in the recent crisis) was the German government’s rescue of IKB and of other small-to-medium-sized institutions at a significant cost to the taxpayer. By contrast, scores of US banks were allowed to fail since the start of the crisis, most of them (including the very large case of Washington Mutual) through the Federal Deposit Insurance Corporation’s receivership procedure that has no direct equivalent in many European countries. This difference can partly be traced back to long-term historical legacies and attitudes to risk and failure.
  • Third, the interdependence between banking and political systems tends to be high in Continental Europe, though difficult to assess quantitatively in comparative perspective. Significant segments of Europe’s banking industry are constituted of non-commercial banks such as savings banks and mutual’s whose governance often directly involves elected officials, as in Spain or Germany, as well as directly state-controlled institutions such as Poland’s PKO BP or Germany’s Landesbanken. France’s tightly knit financial establishment, which brings together both senior regulators and senior bank executives, is another example of such interdependence. While the features vary markedly from one country, there is ample scope for capture of the policy debate and process by the industry’s dominant players.
  • Fourth, nationalism continues to play a significant role in shaping Europe’s financial policy choices which tend to differentially protect and favour domestic “banking champions”, in spite of the non-discriminatory principles enshrined in EU treaties and their increasingly assertive enforcement by the European Commission. One result has been a near-generalised preference for intra-country bank mergers rather than cross-border ones, especially in larger Western European countries. This has tended to exacerbate the too-big-to-fail problem, both before the crisis and since its start.

The discussion on possible remedies to the too-big-to-fail problem is not a simple one, and no silver bullet is at hand. There are different dimensions to the problem, each of which is associated with different policy options: absolute bank size (which may be addressed with size caps or capital surcharges), market concentration (which calls for competition policy or limits to market share), conglomeration (Glass-Steagall-like separations, or the more recent Volcker rule), internationalisation (requirements for local funding and/or capitalisation), and complexity (central clearing of transactions, living wills). Depending on the context, definitions of systemically-important financial institutions generally rely on a mix of these criteria. But many gaps remain in our analytical understanding of the too-big-to-fail problem. Furthermore, much of the available research tends to be focused on the US case, whose features may not be easily extrapolated to non-US contexts (Demirgüç-Kunt and Huizinga 2011).

However, these analytical gaps should not be taken as an excuse to avoid an in-depth debate on the too-big-to-fail problem in Europe; on the contrary. Moreover, given the potential risks to systemic stability, there is a case for policy action even in the absence of analytical certainty. The very large too-big-to-fail problem faced by most European countries should motivate a broad policy discussion on how to reform banking structures in Europe to mitigate it. The sooner the better.

References

 

Posted at 03:07 PM in Other Articles |

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