'Too Big to Fail' From an Economic Perspective

JAN 2014 Source: Global Markets Institute
TOPIC: Global Markets Institute

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'Too big to fail' from an economic perspective

Since the crisis, regulators have significantly enhanced the regulation and supervision of the largest US banks (US G-SIFIs). While some issues remain to be ironed out, most of the key steps to protect taxpayers from absorbing losses from a failing bank have already been put in place. Most notable are the initial “lines of defense” to protect against future bank failures: higher and stronger capital requirements and the improved associated incentives for equity holders. Regulators are now finalizing further lines of defense that would come into play if the first lines fail: resolution procedures and further loss-absorbing capital requirements. An analysis based on statistical models shows that once all of these new lines of defense are in place, US G-SIFIs could withstand a “once-in-several-centuries” crisis, meaning that the risk of inflicting losses on US taxpayers should be extremely remote.

Even before Basel III comes into full effect, capital levels at the 8 US G-SIFIs are already more than twice their pre-2008 levels. Today, the US G-SIFIs could easily withstand a CCAR-like shock and still remain compliant with minimum capital rules, whereas before 2008 they could not have come close. Beyond higher capital, additional lines of defense already in place include shareholder and management incentives that are now better aligned with systemic safety, as well as heightened regulatory and market scrutiny for US G-SIFIs, particularly through the CCAR process. As a result, shareholders and management are likely to recapitalize stressed US G-SIFIs during the early stages of trouble – rather than try to earn their way out, as was often the case in the past. US G-SIFIs today are in a similar position to the better-capitalized banks in 2008, with powerful incentives to act early (as the stronger ones did then).

Given the robustness of improved capital levels and incentives, the third line of defense – a “debt shield” that absorbs losses above and beyond existing equity – should only be needed in extraordinary circumstances. This is likely to be either a bank-specific failure at a deeply troubled institution, which would likely require a liquidation of that firm, or an economic disaster of unprecedented proportions, which would likely require an extraordinary policy response. Thus, while there is real value in addressing the remaining issues, it is equally important to place their solutions and the related cost-benefit analysis in the context of both the low probability of their use and the extraordinarily extreme circumstances in which they would be needed.

Steven Strongin
Managing Director, Global Investment Research
Amanda Hindlian
Managing Director, Global Investment Research
Sandra Lawson
Managing Director, Global Markets Institute
Jorge Murillo
Vice President, Global Markets Institute
Koby Sadan
Vice President, Global Markets Institute
Balakrishna Subramanian
Vice President, Global Markets Institute

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