Too Much Too Big to Fail?

LONDON – Obviously, the global financial crisis of 2008-2009 was partly one of specific, systemically important banks and other financial institutions such as AIG. In response, there is an intense debate about the problems caused when such institutions are said to be too big to fail.

Politically, that debate focuses on the costs of bailouts and on tax schemes designed to get our money back. For economists, the debate focuses on the moral hazard created by ex ante expectations of a bailout, which reduce market discipline on excessive risk-taking – as well as on the unfair advantage that such implicit guarantees give to large players over their small-enough-to-fail competitors.

Numerous policy options to deal with this problem are now being debated. These include higher capital ratios for systemically important banks, stricter supervision, limits on trading activity, pre-designated resolution and recovery plans, and taxes aimed not at getting our money back, but at internalizing externalities – that is, making those at fault pay the social costs of their behavior – and creating better incentives.

I am convinced that finding answers to the too-big-to-fail problem is necessary – indeed, it is the central issue being considered by the Standing Committee of the Financial Stability Board, which I chair. But we must not confuse necessary with sufficient; there is a danger that an exclusive focus on institutions that are too big to fail could divert us from more fundamental issues.

In the public’s eyes, the focus on such institutions appears justified by the huge costs of financial rescue. But when we look back on this crisis in, say, ten years, what may be striking is how small the direct costs of rescue will appear. Many government funding guarantees will turn out to have been costless: liquidity support provided by central banks at market or punitive rates will often show a profit, and capital injections will be partly and sometimes wholly recovered when stakes are sold.

Emerging estimates of the total fiscal costs of rescue vary by country, but are usually just a few percentage points of GDP. As a result of this crisis, however, government debt-to-GDP ratios in the United Kingdom and the United States will likely rise by 40 to 50 percentage points, and more important measures of economic harm – foregone GDP growth, additional unemployment, and individuals’ wealth and income losses – will rise as well.

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