Exactly a year ago, Lehman Brothers, the fourth-largest investment bank in the US, filed for bankruptcy and the financial world went into meltdown. Governments around the world rallied to save the world economy, but the state-led resolution of the financial crisis has come at a price. Upfront government financing has reached 5.5 per cent of GDP for advanced economies according to the IMF. This includes capital injection, purchase of assets and lending by treasury and central bank support with treasury backing. If one adds to this the guarantees by treasury, this figure rises to 19.5 per cent.
Quite naturally, countries which are home to large banks are concerned with the threat to public finance and the solvency of the country that would result from the bailout of a large bank. For example, the equity-to-GDP ratio of Royal Bank of Scotland and Credit Suisse stood at 6.5 per cent and 11.7 per cent at the start of the banking crisis, while the same ratio for Bank of America was only 1.1 per cent.
Ahead of the summit later this month of the Group of 20 developed and emerging economies (G20), calls are being heard in Belgium, Germany, the Netherlands and Switzerland to cap the size of domestic banks. Is small beautiful? In a recent research paper, we match bailout cost data collected by the IMF with the relative size of banks and the relative size of banking systems and come to some conclusions.
Of nine countries with large banks, seven have faced large bailout costs. The exceptions are Spain and Switzerland, with a ratio of bailout cost to GDP of 3.9 per cent and 1.1 per cent respectively. And it is clear that some countries with relatively small banks can be hit as well. This is the case in Greece and the US when an economic shock affects many banks, a case of systemic risk. In Greece, it was an exposure to the Balkan countries and the shipping industry, while in the US, it was an exposure to the mortgage market.
So small banks are not a panacea. And capping the size of banks can have an unintended effect: a lack of international credit risk diversification. Such a lack is particularly harmful in countries operating with a single currency with a number of others, as devaluation is not allowed any more to help the economy in recession. Spain is a good example of this. Diversified banks such as Santander or BBVA fare much better than regional domestic cajas.
In addition, large banks are often providers of highly skilled employment in corporate banking and treasury activities. A reduction of bank size will entail the loss of jobs in financial services, a vital sector in a services economy. If reducing bailout cost is the right objective, capping the size of banks is not the best tool. Public policy mechanisms must be developed to allow countries to operate large banks while maintaining a satisfactory level of financial stability.
There are four mechanisms that will allow countries to host large banks: 1. Independence and accountability of supervisory agencies. In the same way as monetary policy is conducted by independent central banks, supervision would be conducted by independent agencies. This would reduce the negative impact of lobbying and short-term political cycles. 2. Prompt and corrective action mechanism. This is to force a prompt resolution of problem banks.
3. Burden-sharing system: bailout costs are shared by a group of countries. Co-insurance will help countries that host large banks. With co-insurance, countries will legitimately want joint supervision of international banks. 4. An end to the "too-big-to-fail" doctrine. Special bankruptcy rules must be developed to allow a swift resolution of bank failures. Bailout cost and moral hazard will be substantially reduced when unsecured bank debt is put at risk.
The recent plans drawn up by the treasury departments in both the US and UK call for a special bankruptcy regime for systemic institutions. It remains to be seen if this is accepted by congress or parliament. Looking back, it was clear that several countries with large banks were facing the potential costly threat of having to bail them out. The banking crisis turned this scenario into reality. Having had their fingers burnt, policy makers are wondering as to whether the size of banks should be capped, the benefit being to reduce the cost of another bailout.
Events have shown, however, that countries with smaller banks are not immune from a costly bailout if correlated systemic risk affects many of these smaller banks. In addition, one should be careful in capping the size of an institution if it implies a reduction of foreign activities and a focus on domestic activities. Good intentions can produce unintended evils if this implies a lack of diversification of risk. And in advanced economies, the services sector provides opportunities for highly skilled employment.
One should give financial institutions the sources of competitive advantage arising from economies of scale and scope. It would seem that increased accountability and burden sharing would go a long way to reduce the risk of another costly bailout. Time will tell. Jean Dermine is professor of banking and finance at Insead and Dirk Schoenmaker is dean of the Duisenberg School of Finance