My analysis suggests three priorities:There seems another obvious way to deal with too-big-to-fail, let the big fail.
First, help address ‘too-big-to-fail’.
The too-big-to-fail problem is a major prudential concern [...]. The Basel III capital surcharges for systemically important banks (up to 2.5% of risk-weighted assets) might be too small to give banks incentives to shrink. Bank competition policy can help address too-big-to-fail.
A blunt approach would be to use competition-policy tools to directly restrict bank size (by limiting mergers, forcing spin-offs, etc.). However it may be hard to restrict size on competitive grounds when banking is contestable and efficient. And since we do not know much about optimal bank size, blunt restrictions may have unintended effects.
A more nuanced approach would be price-based. Competition in banking is distorted because large banks have access to cheaper funding than small banks (thanks to the too-big-to-fail guarantee, as much as 80 basis points cheaper; [...]). Levelling the playing field is a natural area for competition policy. The funding advantage of too-big-to-fail banks can be offset through equivalent taxes or fines (think of a tax on wholesale funding of banks, with a rate that is increasing in bank size). This competition policy measure, as a by-product, would reduce excess incentives for banks to grow, reducing the too-big-to-fail problem.
Recent structural policy initiatives aim to restrict bank or non-bank activities that contribute to systemic risk [...]. These limits would have important interactions with competition policy.If there is a problem with "implicit public guarantees" then do away with the guarantees. In short let banks fail.
The Volcker Rule and the Vickers and Liikanen proposals suggest restricting market-based and, to an extent, international activities of banks. The rationale is that such activities may contribute disproportionately to systemic risk [...]. From a competition perspective, these restrictions might also be desirable. They would allow authorities to use different approaches to less contestable (core) and more contestable (market-based and international) sectors of banking, resulting in a more precise competition policy.
Another structural problem highlighted by the Crisis is excess competition for retail deposits. Retail deposits are the most stable source of bank funding [...]. When deposits are scarce, banks have to rely on unstable wholesale funding. A common reason for the scarcity of deposits is excess competition for household savings – from insurance companies or asset managers (as in Australia or the Nordics) or from local savings banks with implicit public guarantees (as in Germany). Competition policy may help by pressuring governments to level the playing field – deal with implicit guarantees and lax regulation of non-banks.
The Crisis put into sharp relief possible conflicts between bank competition policy and crisis management [...]. Normally, competition policy advocates limited government involvement in banks in order to maintain a level playing field. Yet, crisis management may require governments to take ownership in banks or offer banks guarantees in order to maintain financial stability and the capacity to lend. Also, governments may need to exercise control over banks to direct their restructuring.But does crisis management mean that governments have to take ownership of banks or offer banks guarantees? What is wrong with normal bankruptcy procedures? As Hart and Zingales have written,
In such exceptional circumstances, competition policy should acknowledge the trade-off between preserving the level playing field versus effective bank resolution, and aim for a balance. Also, competition policy might need to temporarily allow higher banking-system concentration, when that is necessary to allow banks to rebuild charter values or to facilitate the shrinking of a previously over-expanded banking-system.
As an example of an effective bankruptcy mechanism, one need look no further than the FDIC procedure for banks. When a bank gets into trouble the FDIC puts it into receivership and tries to find a buyer. Every time this procedure has been invoked the depositors were paid in full and had access to their money at all times. The system works well.
From this perspective, one must ask what would have been so bad about letting Bear Stearns, AIG and Citigroup (and in the future, General Motors) go into receivership or Chapter 11 bankruptcy? One argument often made is that these institutions had huge numbers of complicated claims, and that the bankruptcy of any one of them would have led to contagion and systemic failure, causing scores of further bankruptcies. AIG had to be saved, the argument goes, because it had trillions of dollars of credit default swaps with J.P. Morgan. These credit default swaps acted as hedges for trillions of dollars of credit default swaps that J.P. Morgan had with other parties. If AIG had gone bankrupt, J.P. Morgan would have found itself unhedged, putting its stability and that of others at risk.
This argument has some validity, but it suggests that the best way to proceed is to help third parties rather than the distressed company itself. In other words, instead of bailing out AIG and its creditors, it would have been better for the government to guarantee AIG's obligations to J.P. Morgan and those who bought insurance from AIG. Such an action would have nipped the contagion in the bud, probably at much smaller cost to taxpayers than the cost of bailing out the whole of AIG. It would also have saved the government from having to take a position on AIG's viability as a business, which could have been left to a bankruptcy court. Finally, it would have minimized concerns about moral hazard. AIG may be responsible for its financial problems, but the culpability of those who do business with AIG is less clear, and so helping them out does not reward bad behavior.