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Thursday, May 15, 2014

'Are Banks Too Large?'

I don't think this issue can be addressed without also considering the political power of large banks -- their ability to shape legislation in their favor in a way that increases the risk of financial meltdown:

Are Banks Too Large? Maybe, Maybe Not, by Luc Laeven, Lev Ratnovski, and Hui Tong, iMFdirect: Large banks were at the center of the recent financial crisis. The public dismay at costly but necessary bailouts of “too-big-to-fail” banks has triggered an active debate on the optimal size and range of activities of banks.
But this debate remains inconclusive, in part because the economics of an “optimal” bank size is far from clear. Our recent study tries to fill this gap by summarizing what we know about large banks using data for a large cross-section of banking firms in 52 countries.
We find that while large banks are riskier, and create most of the systemic risk in the financial system, it is difficult to determine an “optimal” bank size. In this setting, we find that the best policy option may not be outright restrictions on bank size, but capital—requiring  large banks to hold more capital—and better bank resolution and governance.
Large banks increase systemic, not individual bank risk
Large banks have significantly grown in size, and become more involved in market-based activities since the late 1990s..., the balance sheet size of the world’s largest banks increased two to four-fold in the 10 years prior to the crisis. ...
Also, large banks appear to have a distinct, seemingly risky business model. They tend to simultaneously have lower capital..., less stable funding..., more market-based activities..., and be more organizationally complex..., than smaller banks. ...
In addition, our study confirms that large banks create most of systemic risk in today’s financial system. ... Large banks create especially high systemic risk when they have insufficient capital or unstable funding. And, large banks create high systemic risk...
Too-big-to-fail and empire building
What drives the size and the business model of large banks? Our study suggests the following:
Implicit too-big-to-fail subsidies ... This predisposes large banks to use leverage and unstable funding, and to engage in risky market-based activities.
Possible empire building. ...
Economies of scale. While a good explanation for the size of large banks, recent studies suggest that they are modest. ...
Optimal bank size inconclusive
The evidence that large banks respond to too-big-to-fail and empire building incentives, and in process create systemic risk suggests that banks might become “too large” from a social welfare perspective. But there is an important caveat. We know too little about the value that large banks bring to their customers (e.g., large global corporations). The potential for economies of scale in large banks cannot be dismissed. As a result, we cannot draw conclusions as to the socially optimal bank size. And it also implies that outright restrictions on bank size or activities may be imprecise and hence costly. ...

    Posted by on Thursday, May 15, 2014 at 10:14 AM in Economics, Financial System, Market Failure | Permalink  Comments (39)

          


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