‘Too big to fail’ is still a threat

Opinion: the problem is not only the subsidy for bank risk-taking, it is also the likelihood of disasters

“The total assets of a number of big banks have continued to soar: institutions with assets of $2 trillion are common. Such banks remain highly interconnected, though the extent of this might have diminished recently.” Photograph: Andy Sacks/Getty Images

“The total assets of a number of big banks have continued to soar: institutions with assets of $2 trillion are common. Such banks remain highly interconnected, though the extent of this might have diminished recently.” Photograph: Andy Sacks/Getty Images

Wed, Apr 16, 2014, 01:00

No solvent government will allow its banking industry to collapse. Leveraged institutions whose liabilities are more liquid than their assets are vulnerable to panics. In a panic, it will be hard to distinguish illiquidity from insolvency. These three points shape my views: the state stands behind banking even though it might not stand behind individual institutions.

One of the obstacles to making the bearing of losses by creditors credible is “too big to fail” – the challenge posed by banks that are individually systemic.

A question about post-crisis regulation is whether this risk is gone. The answer is no. Mark Carney, the governor of the Bank of England and chairman of the Financial Stability Board, agrees that “firms and markets are beginning to adjust to authorities’ determination to end too-big-to-fail. However, the problem is not yet solved.”

No it is not, as a chapter on banks in the latest Global Financial Stability Report from the International Monetary Fund shows. “Subsidies rose across the board during the crisis but have since declined in most countries,” it concludes. “Estimated subsidies remain more elevated in the euro area than in the US. . . All in all, however, the expected probability that systemically important banks [SIBS]will be bailed out remains high in all regions.” Moreover, in another crisis, the necessary subsidies might jump once again.

One reason is that the banking sector has tended to become even more concentrated. Furthermore, the total assets of a number of big banks have continued to soar: institutions with assets of $2 trillion are common. Such banks remain highly interconnected, though the extent of this might have diminished recently.

Another reason is that the subsidies are still large. The IMF notes there are three different ways of assessing the subsidy. The first is from the difference between the interest rates on bonds issued by SIBs and non-SIBs. The second is a “contingent claims analysis”. The third comes from the analysis by rating agencies of the gap between the standalone rating and one allowing for state support.

Comparisons between interest rates on bonds paid by SIBs and non-SIBs are quite tricky. Nevertheless, the contrast between US institutions with comparable leverage ratios (ratios of total assets to equity) reveals that the SIBs have a funding advantage. This confirms that the subsidy does indeed endure.

The second approach is based on comparing observed spreads on credit-default swaps (a form of insurance on bonds) with fair-value spreads derived from prices of equities. The CDS spreads – unlike data from equities, whose owners are unlikely to be protected – take account of the probability of distress and the likelihood and size of government support. This method shows huge support during the crisis, which then declines in the US and rises in the UK and euro zone.

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