Tuesday, June 30, 2009

Banks Too Big To Fail

The Governor of the Bank of England recently stated that 'if a bank is too big to fail - it is too big.'

I agree with his sentiments of strengthening bank regulation. But, one question is what size bank would be too big to fail?

In terms of public confidence the size of a bank is not that important. Even if the smallest bank like, for example, the co-operative bank went bust, the impact on confidence would be very damaging. Even a small bank going bankrupt could cause a run on bank deposits and cause nervous savers to keep cash under their bed.

The UK's largest bank like Lloyds TSB / HBOS has too much monopoly power (at 31% of market share). There is a good case for breaking up the merger. But, even if it was broken up, would not the two banks still be too big to fail? So when the Chancellor says 'its more complicated than just the size of the bank' he does have a fair point. After all, Lehman Brothers was by no means the biggest bank, but, its bankruptcy is widely seen as a tipping point in the credit crunch becoming very serious.
Moral Hazard and Bank Bailouts

Often economists refer to moral hazard. (see: Moral Hazard and Banks). This is the idea that agents can be influenced to take bad economic decisions. For example, the promise to bailout banks may encourage the banks to take risky decisions in the future. This point is not without merit. The likelyhood of a government bailout could encourage some risky behaviour. However, I think the argument is often overated. Northern Rock didn't pursue its business plan of borrowing on short run money markets because it knew the government would eventually have to bail it out. It pursued its business plan because it really thought this was a short cut to profitability. If the government had said in 2000, - there is absolutely no chance of nationalisation should you you run out of cash, I don't think Northern Rock or any bank would have behaved differently.

Where there is moral hazard is in the bonus culture of many bank executives. As mentioned before pay schemes reward risky - high return investment with no penalty for losing money. This is something banks (if necessary through government regulation) need to address.

Sometimes, free market economists say it's too difficult to regulate banks, banks will just find ways around the regulation. But, this is a lazy approach. Just because bank regulation is not straightforward doesn't mean we shouldn't try. After all, the alternative of hoping for responsible self-regulation has proved to be a total failure.

There are areas where bank regulation can improve. Not least
  • - Requiring a certain reserve ratio - especially during boom times.
  • - Limiting the % of funding which comes from short term money markets.
  • - Regulating bonus culture.
But, note, regulating the size of banks will not solve the problem - alot more is needed

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