Too big to fail

3 The economics of how to mitigate TBTF

Figure 1 (Section 2) already gives a clue of how to design policies to mitigate the TBTF problem: by reducing risks and by improving the ability of authorities to deal with failures once they have happened. The better governments can deal with failing banks without bailing them out, the lower are banks’ funding cost advantages, the better are private and public interests aligned, and the lower the costs for the taxpayer.

In fact, after the global financial crisis, all these policies were introduced (Section 4). Let’s see how these policies work.

Capital requirements and supervision

The first element of reforms addressing the TBTF problem is to reduce the probability that a bank fails—the ‘probability of default’—causing losses to the rest of the financial system and the wider economy. Of course, the business model of banks is to make risky loans, so all banks manage the risk that some of their loans are not repaid. But in the absence of regulation, they do not manage the risks that they impose on others. The moral hazard problem that causes systemic risk externalities can lead to situations in which banks take decisions that increase their profits, but are not in the interest of taxpayers and depositors. They may take too much risk, knowing that if it goes wrong, others will pay the price.

capital requirements
A rule requiring banks to meet or exceed a certain capital ratio. The ratio is calculated by dividing available capital by risk-weighted assets. This rule is necessary because banks take risks. For example, there is the risk of a borrower being unable to repay their loan (credit default risk) or financial market prices becoming unfavourable for the bank (market risk). In order to protect its creditors, the bank therefore needs sufficient equity capital to absorb any losses arising from this risk. Source: Bundesbank glossary. See also: leverage ratio (for banks or households).
principal–agent relationship
This relationship exists when one party (the principal) would like another party (the agent) to act in some way, or have some attribute that is in the interest of the principal, and that cannot be enforced or guaranteed in a binding contract. See also: incomplete contract. Also known as: principal–agent problem.
incomplete contract
A contract that does not specify, in an enforceable way, every aspect of the exchange that affects the interests of parties to the exchange (or of others).

Taxpayers and depositors thus delegate power to regulate and supervise banks to public authorities who have, in essence, the role of aligning private and social incentives and making sure that banks do not take on excessive risks. Capital requirements are an important regulatory instrument for banks.1 Minimum capital requirements provide buffers against unexpected losses, and they incentivize banks to properly manage risks by requiring shareholders to absorb losses.

‘Too big to fail’ is a principal-agent problem, where the government is the principal and the bank is the agent. As in all principal-agent problems, there is (a) a conflict of interest, in this case between the government and the bank, concerning (b) a choice by the bank that is not subject to a complete contract, namely the level of risk taken by the bank. The contract is incomplete because the government cannot impose its choice of business strategies on the bank. But it can raise the cost of risk-taking by the bank by imposing capital requirements and thereby reduce the probability of failure.

Section 6.10 of The Economy 1.0 (Section 6.15 of Economy, Society, and Public Policy) explains why principal-agent problems arise, and Section 10.12 of The Economy 1.0 (Section 9.10 of Economy, Society, and Public Policy) discusses principal-agent problems in the context of credit markets.

Recall the balance sheet of a typical bank, as discussed in Section 10.7 of The Economy 1.0. The bank’s equity measures its net worth, typically a small percentage of a bank’s balance sheet. From the perspective of the bank’s creditors and the financial system, equity is a buffer: it absorbs losses until it is depleted. That is why bank regulators intervene to make sure that there are sufficiently large buffers to actually absorb losses.

Prior to the global financial crisis, however, bank capital regulation did not differentiate between banks that are systemically important and those that are not. In other words, it ignored the systemic risk externalities of large and complex banks. Hence, banks had incentives to become TBTF and to engage in excessive risk taking.

If large and systemically important financial institutions are required to meet additional capital requirements, this reduces their incentives to grow inefficiently large and encourages them to take the true social costs of their risk-taking into account. Higher capital in individual banks also makes the financial system more stable: if a bank has more capital to absorb losses, this reduces the need to reduce their supply of lending if they experience losses. Deleveraging, that is, the shrinking of banks’ balance sheets in times of crisis, is mitigated, which is good for the real economy.

Pigouvian tax
A tax levied on activities that generate negative external effects so as to correct an inefficient market outcome. See also: external effect.

Capital requirements that internalize negative external effects of banks being TBTF are very similar to a Pigouvian tax, which internalizes environmental external effects, while raising costs for the firms affected. The withdrawal of implicit TBTF subsidies results, similarly, in an internalization of external effects. It works through an increase in banks’ funding costs. Like the introduction of a pollution emission tax, an increase in funding costs will be perceived as a cost by private market participants. But at the same time, external effects and costs of financial crises to the taxpayer decline. The difference is that tax increases can be directly observed. Funding subsidies for TBTF banks are implicit, in other words, we cannot directly observe their withdrawal. (We will return to the measurement issue in Section 5.)

To learn more about Pigouvian taxes and how they work mathematically, read Section 12.3 and Leibniz 12.3.1 of The Economy 1.0. The Great Economist box in Section 12.3 describes the life of Arthur Pigou, the inventor of the Pigouvian tax.

In addition, institutions that monitor and mitigate systemic risk are needed. Prior to the global financial crisis, central banks were mainly in charge of ensuring price stability, and microprudential supervisors were in charge of ensuring the safety and soundness of individual financial institutions. But no designated public authority was typically in charge of monitoring whether systemic risk in the financial system was building up, or doing something about it.

microprudential supervision
The supervision of individual institutions, which mainly involves supervisors overseeing compliance with qualitative (e.g. risk management) and quantitative (e.g. capital) requirements. Source: Bundesbank glossary. See also: capital requirements.
macroprudential policy
Measures that intend to ensure that market participants take a cautious approach to risks that could affect the whole financial system (systemic risks). Prudential policies relate to actions that promote sound practices and limit risk-taking. The prefix ‘macro’ indicates that the policies or actions relate to the whole or significant parts of the financial system rather than individual financial institutions. Source: ECB – Explainers. See also: systemic risk.

Hence, macroprudential regulation and surveillance was created as a new policy area. The term may not sound very intuitive, but it is really about ensuring that the financial system can function, even in times of stress. As we have seen in Section 2, a functioning financial system intermediates between savers and investors, funds investment projects, and ensures the smooth running of the payments system at all times.

Resolution regimes

Higher capital buffers increase the resilience of banks while they are solvent and operating as a going concern. The second element of the policy reforms was to deal better with the failure of a bank (in other words, as a ‘gone concern’). Bank regulation is not intended to prevent banks from taking risks, as that is a basic feature of the business of banking, and it is inevitable that some banks will fail. Indeed, in a competitive market, entry and exit are desirable to stimulate innovation. What is important is that the failure of a bank can be managed in an orderly fashion so that its critical functions are preserved and losses to the economy are minimized.

Moreover, if a crisis strikes, governments need to be prepared to handle the failure of a systemically important bank. When a non-financial firm or a smaller bank is insolvent, it is wound up through bankruptcy proceedings. We saw in Section 1 that the bankruptcy of Lehman triggered a global financial crisis. Hence, a special mechanism is needed to deal with large or highly interconnected banks that are failing.

resolution
The process of closing or restructuring a bank without interrupting its critical economic functions. Bank shareholders and some or all of the bank’s creditors bear the losses, instead of taxpayers. One approach to resolution is bail-in. See also: bail-in.

The process of closing or restructuring a bank without interrupting its critical economic functions is called resolution. Banks can be resolved in a number of ways, but in all approaches, losses are imposed not on taxpayers or bank customers but on bank shareholders and on some or all creditors.

bail-in
A bail-in resolution is a way of allocating losses to a bank’s shareholders and potentially to some of its creditors. The bail-in procedure follows a legal order of priorities in terms of liability (‘liability cascade’). The first step is to write down the bank’s equity capital to reflect the losses incurred. If these funds are insufficient, other liabilities, such as bonds, are written down or converted into equity.

One approach to resolution is bail-in. The bail-in procedure follows a ‘liability cascade’. The first step is to write down the bank’s equity to reflect the losses incurred. If these funds are insufficient, others bear the losses. This step takes place when liabilities, such as bonds, are written down (have their value reduced) or converted into equity. Among others bearing losses are also those depositors whose deposits are not covered by deposit insurance. In the final step, the deposit insurance scheme (run by financial authorities) may absorb some losses in lieu of insured depositors. For example, in the European Union, private deposits of less than €100,000 are covered by deposit insurance and will not be used in a bail-in. But bailing in other depositors, which may include charities and local public authorities, can still be a politically sensitive decision. That’s why having liabilities that absorb losses before depositors do—this is called ‘loss absorbing capacity’ or LAC—is important.

The next section will explain that post-crisis reforms have introduced a type of liability that is explicitly at risk of being bailed in should there be a bank failure.

Question 4 Choose the correct answer(s)

Which of the following policies would effectively manage the moral hazard cost associated with the expectation of implicit government subsidies?

  • increasing the loss absorbency of financial institutions
  • requiring every financial institution to self-evaluate their moral hazard and publish an annual moral hazard cost report
  • increasing taxes on financial institutions in order to increase their funding costs
  • requiring a detailed resolution plan from relevant financial institutions, which includes information on how potential losses would be covered
  • Increasing capital forces financial institutions to have more ‘skin in the game’: if the bank loses money, investors pay more of the losses with their own money, which lowers incentives for excessive risk-taking.
  • A self-evaluation of moral hazard is unlikely to be an accurate description or to change behaviour in a significant way. That is because the underlying incentives that gave rise to moral hazard remain unchanged.
  • The instruments that are used to internalize negative external effects, such as higher capital requirements, indirectly ensure that markets price risks better. By contrast, an increased tax on bank profits would not reduce the incentives of TBTF banks to take on too much risk.
  • An orderly resolution plan (‘living will’) reduces the need for a government bailout, thereby forcing investors to assess and price risk.

Question 5 Choose the correct answer(s)

Which of the following statements best describes what happen if there is a bail-in resolution regime in place?

  • only equity owners lose money if a bank faces losses
  • deposit insurance is paid to private retail depositors
  • losses may be allocated to the bank’s shareholders and bondholders
  • the government spends public money to cover a bank’s losses
  • While equity capital is the first line of defence against losses, it also absorbs losses even without a resolution process.
  • The deposit insurance scheme means that private deposits up to a specified amount will not be used in a bail-in. However, deposits are the last step in the liability cascade so are not a key feature of a bail-in.
  • Capital and liabilities are among the sources of loss absorbing capacity.
  • If governments cover losses of banks instead of imposing losses on creditors, this is called a bailout.
  1. Mathias Dewatripont and Jean Tirole. 1994. The Prudential Regulation of Banks. Cambridge, MA: MIT Press.