"Today’s most dangerous government sponsored enterprises are the largest six bank holding companies: JP Morgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs, and Morgan Stanley. They are undoubtedly too big to fail – if they were on the brink of failure, they would be rescued by the government, in the sense that their creditors would be protected 100 percent. The market knows this and, as a result, these large institutions can borrow more cheaply than their smaller competitors. This lets them stay big and – amazingly – get bigger.
In the latest available data (Q3 of 2010), the big 6 had assets worth 64 percent of GDP. This is up from before the crisis – assets in the big six at the end of 2006 were only about 55 percent of GDP. And this is up massively from 1995, when these same banks (some of which had different names back then) were only 17 percent of GDP. No one can show significant social benefits from the increase in bank size, leverage, and overall riskiness over the past 15 years. The social costs of these banks – and their complete capture of the regulatory apparatus – are apparent in the worst recession and slowest recovery since the 1930s."
Arguably, the two biggest policy problems with modern financial markets relate to the nature of financial institutions - their size and their financing pattern. (Paul Krugman sees the shadow banking sector as another problem) Bankers point to the economies of scale benefits of large bank holding companies to refute the TBTF arguement. They also warn that increased equity requirements would restrict lending and impede growth.
As Simon Johnson pointed out, there is very little or no research evidence to support either arguments. The most pro-market of financial market economists, Eugene Fama has argued that too-big-to-fail (TBTF) is "perverting activities and incentives" in financial markets and is giving big financial firms "a license to increase risk; where the taxpayers will bear the downside and firms will bear the upside".
A number of the most distinguished American finance acedemics recently questioned the claim that greater equity requirements would adversely affect financial market efficiency,
"Using more equity changes how risk and reward are divided between equity holders and debt holders, but does not by itself affect funding costs. Tax codes that provide advantages to debt financing over equity encourage banks to borrow too much. It is paradoxical to subsidize debt that generates systemic risk and then regulate to try to limit debt...
Ensuring that banks are funded with significantly more equity should be a key element of effective bank regulatory reform. Much more equity funding would permit banks to perform all their useful functions and support growth without endangering the financial system by systemic fragility. It would give banks incentives to take better account of risks they take and reduce their incentives to game the system. And it would sharply reduce the likelihood of crises."
Mark Thoma attributes the persistence of TBTF institutions, despite the overwhelming evidence of their riskiness to regulatory capture. He writes,
"The potential costs of too big to fail banks are large and well known, and unless there are demonstrable benefits to offset the known costs, there is sufficient basis for breaking the banks up. But yet, with scant evidence of the benefits, but plenty of evidence about the costs, too big to fail banks not only persist, the banks are getting bigger. To me, that speaks directly too regulatory capture, and not in a kind way."
Update 1 (15/1/2011)
Simon Johnson has another excellent post on Goldman Sachs' denial of the TBTF problem. See this presentation and paper by Prof Anat Admati that clearly refutes the ("equity is expensive") notion that higher capital requirements will adversely affect banks competitiveness and innovation. She writes,
"We conclude that bank equity is not socially expensive, and that high leverage is not necessary for banks to perform all their socially valuable functions, including lending, taking deposits and issuing money-like securities. To the contrary, better capitalized banks suffer fewer distortions in lending decisions and would perform better. The fact that banks choose high leverage does not imply that this is socially optimal, and, except for government subsidies and viewed from an ex ante perspective, high leverage may not even be privately optimal for banks.
Setting equity requirements significantly higher than the levels currently proposed would entail large social benefits and minimal, if any, social costs. Approaches based on equity dominate alternatives, including contingent capital. To achieve better capitalization quickly and efficiently and prevent disruption to lending, regulators must actively control equity payouts and issuance. If remaining challenges are addressed, capital regulation can be a powerful tool for enhancing the role of banks in the economy."