Tuesday 29 November 2011

Tackling "too big to fail" banks

Banks that are too important to fail can bring a global economy to its knees.  If financial institutions are too big to fail, then disastrous incentives are created: banks are encouraged to take excessive risks.  Why?  Well, if the risk pays off, the benefits are privatised (the bank profits) but if they fail, the costs are socialised (through bailouts from the taxpayer).  Hence, banks are not subject to market discipline - moral hazard is created.

There are several ways to tackle this "too big to fail" problem.  First, banks that have too large a market share can be forced to sell off some of its branches.  Second, the retail and investment arms can be ringfenced.  Third, (as is currently deficient in the USA) a strong safety net for individuals can be created.  This will enable governments to allow organisations to fail without allowing individuals to.  Firms should be allowed to fail, but not individuals.

However, these solutions bring its own problems.  The first solution assumes that market share is the problem with banks that are too big to fail - often this is not the case.  Market share may be a unwise barometer for breaking up banks since the problem may take other forms - for example, the level of exposure other firms and individuals have to that bank.  The second solution, suggested by the Vickers Report, may not tackle the too important to fail problem: for example, if Barclays Capital was about to fail, no sensible government would allow it to do so in light of the level of employment and pension funds it holds.  The third solution assumes that creating a strong safety net equates to not allowing an individual to fail.  However, perhaps it is precisely that that means an individual is failed - they are unemployed.

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