Friday, May 8, 2009

New Regulations And Capital Requirements Will Not Prevent Too Big To Fail

Banking is a highly concentrated industry. There are about 5500 FDIC insured banks in the US with the top 10 banks holding most of the assets, loans, and deposits.

There are certainly economies of scale in banking in the larger institutions, but the next lower size tier of banks also probably benefit from many, if not all, of the same economies of scale. Economies do not explain by themselves the extreme concentration of banking. There may be even diseconomies and extra costs for the very large banks in comparison to the next lower tier, smaller banks.

There is a too big to fail size that some large banks strive to reach that offsets the extra costs and diseconomies of the top banks’ size. The extra costs of proposed new constraints and regulations have to be so great as to completely negate the benefit of being too big to fail. We do not have the quantitative data to be sure what kind of new requirements will effectively do the job.

Breaking up big banks is OK if most of the positive benefits of the scale economies remain. Otherwise, we are imposing new banking costs on the customer. The change and extra costs will force an unpredictable behavioral effect at the consumer level of banking with unintended economy wide results.

Stringent regulations and higher capital requirements will not prevent too big to fail banks. Larger banks that can realistically reach a too big to fail size have too much risk taking incentive. These banks will find the weaknesses in the new regulations through analysis or trial and error. Then, these banks will take additional risks in less well-regulated, costly areas until they reach a too big to fail size.

The incentive to become a too big to fail bank is huge. Once a bank reaches a too big size, the bank can take an inordinately large amount of business risk in an attempt to produce a very large amount of income. It becomes a gambler that can bet its entire stake, the whole bank, on a single risky bet without fear that if it loses, it will no longer be able to continue gambling, i.e. the bank will be closed.

The best alternative may be to phase out the too big to fail doctrine completely. However, the banks and the government are then playing a game of chicken, or poker. Will the government really let there be a very large bank failure? Could a bank grow very large just to see if the government is bluffing?

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