Academic journal article Accounting & Taxation

Does a Size Limit Resolve Too Big to Fail Problems?

Academic journal article Accounting & Taxation

Does a Size Limit Resolve Too Big to Fail Problems?

Article excerpt

ABSTRACT

Does limiting the size of a large bank reduce its insolvency risk? This paper shows that the answer to this question depends on how exactly paring down of the bank size is done. In fact, the insolvency risk may go down or up depending on the composition of assets and liabilities of the bank relative to its pre-paring down composition. In addition, this study investigates mean-standard deviation efficiency of a typical Canadian large bank and its various possible paring down scenarios and finds both the original bank and its pared-down versions are inefficient. It then suggests mean-standard deviation efficient compositions of assets and liabilities, which do not depend on limiting the size of the bank. Therefore, the findings of this paper raise a serious doubt about the validity of the "limit on size" solution to the too-big-to-fail problem.

JEL: G21, G01, G18

KEYWORDS: Banking, Too-Big-To-Fail, Assets and Liabilities Management, Mean-Variance Analysis

(ProQuest: ... denotes formulae omitted.)

INTRODUCTION

During and after the 2007-2009 financial crisis, the term too-big-to-fail, to be denoted by TBTF hereafter, has been commonly used for a bank that is so large that its failure will trigger significant adverse financial and economic consequences for both financial and non-financial sectors (Ashcraft, 2005). These consequences termed the spillover effects, or systemic risk, were the main rationale behind governments' bailouts of large troubled banks in the USA and Europe during the crisis. The public rescue of a financially distressed large bank is known as the TBTF policy.

The gains of the TBTF policy are the avoidance of the expected spillover effects and maintenance of financial stability, but this policy involves both short-run and long-run costs. Johnson and Kwak (2010) and King (2009), among others, argue that TBTF policy creates moral hazard problem and thereby encourages excessive risk-taking and inefficiency in resource allocation in the long-run. In addition, with the TBTF policy, the frequency of future financial crises is expected to rise, which will entail more significant financial and real costs (Goodlet, 2010). The short-run costs of the TBTF policy consist of the bailout funds which are a transfer of wealth from taxpayers to financial industry. Stem and Feldman (2009a) report that long-run costs were three times the short-run costs of rescuing the savings and loans associations in the USA in the 1980s. Because of the short-run and long-run costs and competitive nonneutrality in favor of large banks of the TBTF policy, this policy is termed to be the TBTF problem.

Various measures have been proposed to tackle the TBTF problem such as, limit on size, tax on profit of TBTF banks, improving bank governance, raising capital adequacy requirements for TBTF banks, and embedded contingent capital (for a comparative evaluation of all the possible solutions to the TBTF problem that have been covered in the extant literature, see Rashid et al., 2012). Among these measures, the "limit on size" solution has been more popular in policy and academic circles. In Belgium, the Netherlands, Switzerland, U.K, and USA, calls have been heard to cap the size of domestic banks (Dermine and Schoenmaker, 2010). A sample of prominent observers who have promoted limiting the size of large financial institutions are Reich (2008), Schultz (2008), Greenspan (see Buiter, 2009), Drucker (see Dickson, 2010), King, Ex-exchequer U.K (see Treanor, 2009), Johnson and Kwak (2010), and Moosa (2010).

As stated by Stern and Feldman (2009b), the size limit solution has seemingly two attractive features that make it more popular and appearing easy to implement in practice. First, a bank's size is easily measurable. Second, the regulator can simply order across-the-board shrinkage of balance sheets for TBTF banks. However, a deeper analysis shows that the difficulties in implementing the "limit on size" solution are more serious than pretended by many of its advocates. …

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