Friday, June 19, 2009

Addressing the too big to fail problem

In my last post, I highlighted that central banks and regulators have begun to focus on this issue with renewed interest.

In its Financial Stability Report, the Swiss National Bank suggests three ways in which this problem can be addressed:

There are three basic strategies for resolving, or at least alleviating, the ‘too big to fail’ problem. First, one can impose very strict capital and liquidity regulations on systemically important financial institutions. This can reduce both the likelihood of government assistance being required and the cost of such an intervention. Moreover, strict capital requirements reduce moral hazard, by forcing banks to themselves bear more of the risk of losses, and also reduce the banks’ incentive to inflate their balance sheets. ...

Second, one can adapt the legal framework and the financial market infrastructure to simplify, or make possible,an orderly wind-down of large financial institutions during periods of severe crisis.
Third, one can directly tackle the cause of the ‘toobig to fail’ problem by limiting the size of financial institutions. One could consider direct size restrictions, forinstance by imposing a maximum market share or balancesheet-to-GDP ratio, or indirect incentives – as mentioned
above – such as increasingly strict capital requirements for big banks.


Anonymous said...

Are banks really inflating their balance sheets? In the originate and distribute model of securitization banks have been working to reduce their balance sheets proactively.
This reduces their capital requirements and fee income becomes more lucrative.

Raj said...

Ram, nothing to do with this post, but can I request you to post one on the implications of the 'negative inflation" ?

michaeld said...

It looks like the financial crisis is abating, especially in light of last week's record debt auction by the U.S. Treasury.

Banks should do well in the long term.


kvv said...

"Too big to fail is too big to exist"
- Simon Johnson (ex IMF chief economist)

He thinks the US now has a powerful financial oligarchy that needs dismantling:
The Quiet Coup