The phenomenon of toobigtofail and its impact on the financial stability

Digest World Bank Research Volume l Number l Fall 2010 Too Big to Fail or Too Big to Save? strong incentives to reduce their size relative to the national economy Indeed, a smaller percentage of banks were systemically important (relative to GDP) in 2008 than in the two previous years (figure 1) The problem of “too big to save” facing systemically large banks in fiscally strapped countries is likely to change the structure of the international banking system Banks in all financial systems will face pressure to deleverage in order to reduce risks for themselves and for the financial safety net But systemically large banks in fiscally constrained countries will have particularly strong incentives to downsize in order to be able to rely on the financial safety net in the future The evidence suggests that downsizing should increase bank valuation The downsizing that occurred in 2008 thus may have been driven in part by a desire to increase stock market valuation in the face of the too-big-to-save effect—even if losses and difficulties in raising equity and other types of capital at a time of financial crisis also played a role (continued on page 7) Figure Systemically Large Banks as a Percentage of Publicly Listed Banks in Selected Countries, 1991–2008 12 10 Big0.1 Percent Big0.25 Big0.5 Big1.0 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 91 19 I n financial regulation, “too big to fail” has become a key issue Indeed, during the recent crisis many financial institutions received subsidies precisely because they were deemed too big to fail by policy makers The expectation that large institutions will be bailed out by taxpayers any time they get into trouble makes the job of regulators all the more difficult After all, if someone else will pay for the downside risks, institutions are likely to take on more risk and get into trouble more often The many implicit and explicit benefits that governments are willing to extend to large institutions make reaching too-big-tofail status a goal in itself for financial institutions Thus all the proposed legislation to tax away some of these benefits But could it be that some banks have become too big to save? This is a valid question, particularly for small countries or those with deteriorating public finances The prime example is Iceland, where the banking system’s liabilities rose to about nine times GDP at the end of 2007, before its spectacular collapse in 2008 By the end of 2008 the liabilities of publicly listed banks in Switzerland had reached 6.3 times GDP, while the liabilities of those in the United Kingdom had risen to 5.5 times GDP In a recent paper Demirgỹỗ-Kunt and Huizinga investigate whether market valuation of banks is sensitive to government indebtedness and deficits Markets may doubt the ability of financially strapped countries to save their largest banks At the very least, governments in this position may be forced to resolve bank failures in a relatively cheap way, implying large losses to bank creditors The authors investigate the impact of a country’s public finances, in the form of both government debt and deficits, on expected returns to bank shareholders as discounted in bank stock prices They also distinguish between systemically important and smaller banks In a parallel fashion, they consider the impact of government finances on expected losses on banks’ liabilities, as reflected in fiveyear credit default swap (CDS) spreads Specifically, they consider bank valuation in 1991–2008, with 717 publicly listed banks in 34 countries in 2008, and CDS spreads in 2001–08, with 59 banks in 20 countries in 2008 Overall, the authors find that while systemically large banks may benefit more than smaller banks from taking on more risk, they can also suffer from being in a country that runs large government deficits at a time of financial crisis This makes the net benefit of systemic size ambiguous The results also suggest that some banks may have grown beyond the size that maximizes their implicit subsidy from the financial safety net Such banks can increase shareholder value by downsizing or splitting up For the overall sample, the results suggest that the share price of systemically important banks is discounted 22.3 percent on average because of systemic size, providing 19 Systemically large banks may face private incentives to downsize Note: The figure shows the percentages of banks with a ratio of liabilities to GDP exceeding various thresholds for 34 countries Big0.1 shows the percentage with a ratio exceeding 0.1, Big0.25 the percentage with a ratio exceeding 0.25, Big0.5 the percentage with a ratio exceeding 0.5, and Big1.0 the percentage with a ratio exceeding 1.0 Digest World Bank Research Interactions between Formal and Informal Institutions The reliability of the production process is a physical channel through which development can influence institutions I n many developing and transition economies informational and contracting constraints make it more difficult for enterprises to business These constraints are perceived to stem mainly from dysfunctional formal enforcement institutions, such as courts To deal with these constraints, enterprises use informal mechanisms of contract enforcement based on reputation, networks, and relationships There is ample evidence of this from around the developing and developed world Existing studies consider formal and informal institutions to be full substitutes But this is unrealistic, since these two modes of governance are extremes How formal and informal institutions interact remains a central question A recent paper by Dhillon and Rigolini addresses this open question by developing a new theory of institutional interactions in which formal and informal institutions coexist and influence one another The authors develop a theoretical framework in which unobserved firm-level shocks, related to the level of development, imply the production of poor-quality goods Such shocks generate a moral hazard problem because consumers cannot determine whether poor quality stems from a shock or from firms cheating and intentionally producing goods of low quality To cope with this problem, consumers rely on two enforcement mechanisms: an informal one, based on reputation and networks, which is enhanced through consumers’ investment in being “connected”; and a formal mechanism, which acts through legal enforcement (but can be weakened by firms through bribes) This theory makes two contributions First, it highlights the importance of market prices as a channel of institutional interaction High equilibrium prices affect both the incentives of firms to bribe because of the higher rents involved and the incentives of consumers to connect with one another to identify poorly performing firms At the same time, however, unobserved productivity shocks keep the equilibrium price higher than marginal costs, to encourage firms to foster high quality In particular, the higher the frequency of productivity shocks (a typical feature of low- and middleincome countries), the higher the price must be relative to the actual costs of production This provides a new explanation of why some goods, even in a competitive setting, may be priced higher in low- and middle-income countries Second, the theory suggests a physical channel through which development can influence institutions: the reliability of the production process An unreliable production process affects institutions and the welfare of consumers in several ways Beyond leading to higher equilibrium prices, it provides firms with greater incentives to bribe if a case is brought to court because higher rents are involved In addition, it directs consumers toward informal networks and personal connections in order to identify poorly performing firms Preliminary evidence suggests that such a channel could play a significant role The authors use World Bank Investment Climate Survey data from six regions to study the determinants of firms’ membership in business associations (a proxy for informal connectedness) and of their perception of corruption A firm is considered a member of a business association only if it belongs to the association and recognizes its ability to resolve disputes and provide information on domestic product markets The authors create a corruption variable that accounts for all the firms that identify corruption as an important constraint to business In addition, using the principal components method, they construct a reliability index based on whether firms identify electricity shortages, transport, and skills as important constraints Once country and sector characteristics are taken into account (through fixed effects), the authors observe that in all regions the reliability index has a statistically significant relationship with both membership in business associations and corruption This confirms what the theory predicts: lower reliability of a market is associated with a higher likelihood that a firm is a member of a business association and with higher corruption Amrita Dhillon and Jamele Rigolini Forthcoming “Development and the Interaction of Enforcement Institutions.” Journal of Public Economics (continued from page 3) Too Big to Fail or Too Big to Save? There is an obvious policy interest in reducing bank size to below the point where banks’ national contingent liabilities are so large that there are doubts about governments’ ability to stabilize the banking system This also at least partially explains the current proposals to limit bank size or tax systemically large banks But that the percentage of systematically large banks had already declined in 2008 even without additional regulation and taxation may reflect private incentives to downsize in the face of a too-bigto-save effect in fiscally constrained countries Additional regulation or taxation aimed at very large banks may strengthen this trend Asl Demirgỹỗ-Kunt and Harry Huizinga 2010 “Are Banks Too Big to Fail or Too Big to Save? International Evidence from Equity Prices and CDS Spreads.” Policy Research Working Paper 5360, World Bank, Washington, DC  ... of institutional interaction High equilibrium prices affect both the incentives of firms to bribe because of the higher rents involved and the incentives of consumers to connect with one another... connectedness) and of their perception of corruption A firm is considered a member of a business association only if it belongs to the association and recognizes its ability to resolve disputes and provide... institutions, such as courts To deal with these constraints, enterprises use informal mechanisms of contract enforcement based on reputation, networks, and relationships There is ample evidence of