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.
All of this implies that the crucial problem is not the fiscal cost of rescue, but the macroeconomic volatility induced by precarious credit supply – first provided too easily and at too low a price, and then severely restricted. And it is possible – indeed, I suspect likely – that such credit-supply problems would exist even if the too-big-to-fail problem were effectively addressed.
In the US, this crisis has seen over-exuberant commercial real-estate lending by regional banks. If such banks fail, they are resolved by the Federal Deposit Insurance Corporation (FDIC) in the normal fashion, and this has always been the market’s ex ante expectation. In the UK, similarly, we have had problems with mid-sized mortgage banks, and with poor commercial real-estate lending by mutual building societies, as well as problems with two large banks. Ireland faces huge economic problems as a result of a commercial real-estate boom driven by banks that are relatively small by global standards.
There is therefore a danger that excessive focus on “too big to fail” could become a new form of the belief that if only we could identify and correct some crucial market failure, we would, at last, achieve a stable and self-equilibrating system. Many of the problems that led to the crisis – and that could give rise to future crises if left unaddressed – originated elsewhere.