Friday, January 15, 2010

Too Big Too Fail Does Not Exist And Is Just Rhetoric

it’s well established that larger firms in all sorts of industries have a lower risk premium than smaller but otherwise similar firms. According to Ibbotsons Valuation Yearbook from 2008, the risk premium for the largest 10% of firms is 34 bps below the CAPM rate, and for second largest 10%of firms is 68 bps above it*. So using a standard valuation handbook, firms in the largest decile should borrow at 102 bps below the rate charged for the second largest group of firms. You hardly need to appeal to a too big to fail premium to explain a 78 bps gap between the rates charged to large banks and small banks.
Read Adam Ozimek's interesting blog post on Modeled Behavior, "Who Knew Banks Were Too Big To Fail, And Does It Matter?"

1 comment :

  1. I appreciate that you found my post interesting, but I didn't mean to suggest that too big to fail banks don't exist. My point is that the lower cost of borrowing for large banks that Dean Baker presented as evidence of too big to fail is in fact not evidence, because large firms in general have lower risk premia than otherwise similar small firms.