The TBTF "subsidy"

Some time back I had blogged about the concentration of risks posed by the too-big-to-fail (TBTF) institutions. Apart from the potentially disruptive system-wide risks posed by such concentration of risks, the moral hazard generated (by the near certainty of bailouts in case of failures) creates an implicit public guarantee for such institutions. More specifically, they offer an implicit subsidy (in terms of their borrowing limits and terms) for these financial institutions.

Luigi Zingales and Oliver Hart points to a a recent study by Dean Baker and Travis McArthur who explored the implicit subsidy and resultant advantages enjoyed by the TBTF banks over small banks and found that it increased over the course of the crisis

"Between 2000 and 2007, large banks (those with assets of more than $100 billion) could borrow money at interest rates that were about 0.29 percentage points lower than those available to smaller banks. In the period since, the spread has grown to 0.49 percentage points. This increased spread is the market's estimate of the benefit of the implicit insurance offered to large banks by the "too big to fail" policy.

For the 18 American banks with more than $100 billion each in assets, this advantage corresponds to a roughly $34 billion total subsidy per year. This subsidy distorts the marketplace by hampering the ability of small banks to compete, which in turn leads to greater bank concentration. This increases the power of banks at the expense of depositors and borrowers, and all but ensures that banks will be even bigger the next time a rescue gets called in."

Apart from this, there is the challenge of regulating the TBTF institutions. Accordingly, there have been a chorus of opinions, led by Simon Johnson, calling for breaking up the TBTF banks. Arnold Kling makes the free-market case for breaking up big banks. He finds that no economic efficiency would be sacrificed by limiting the size of financial institutions and such a policy would considerably limit systemic risk. He writes, "Unless there are tremendous advantages of efficiency or systemic stability from having large banks, their adverse effect on the political economy justifies breaking them up."

The Volcker Rule proposed by Paul Volcker advocates strict limits on the size and scope of trading activities of the big banks, including banning proprietary trading operations unrelated to serving customers for its own profit.

Paul Krugman has this explanation of why breaking up the big banks wouldn't take away the threat of runs on the financial system. He favors updating and extending old-fashioned bank regulation to cover the "shadow banking system". More specifically, he feels that regulators need the authority to seize failing shadow banks (just as the Federal Deposit Insurance Corporation has the authority to seize failing conventional banks) and placing prudential limits on shadow banks, above all limits on their leverage.

Update 1 (5/5/2010)
Mark Thoma advocates capping leverage ratios and the size of banks not so much because it would prevent financial crisis, but it would reduce the damage in the event of a financial market collapse