The European Union should start a debate on too-big-to-fail

By Nicolas Véron and Morris Goldstein

14 April 2011

(A version of this column was also published in VOX)

Are banks too big to fail? This column suggests now is the time for Europeans to ask this question. It argues that
given the potential risks to systemic stability, there is a case for policy action even in the absence of analytical
certainty.

The existence of too-big-to-fail financial institutions represents a three-fold policy challenge.

 First, such institutions exacerbate systemic risk by blunting incentives to manage risks prudently and by
creating a massive contingent liability for governments that, in extreme cases, can threaten the latter’s
own debt sustainability; Iceland in 2008-2009 and Ireland in 2010-2011 serve as dramatic, recent cases
in point.

 Second, too-big-to-fail financial institutions distort competition. The 50 largest banks in 2009 benefitted
from an average three-notch advantage in their credit ratings (BIS 2010) -- an advantage presumably
related in part to the higher likelihood of official support at times of crisis.

 And third, the favoured treatment of too-big-to-fail institutions – often summarised as “socialisation of
losses and privatisation of gains” – lowers public trust in the fairness of the system (Johnson 2009).

It is no wonder then that the too-big-to-fail issue is at the forefront of the debate on financial regulatory reform --
as least as seen from Washington DC, London, and Zurich. Federal Reserve Chairman Ben Bernanke testified in
September 2010 that “if the crisis has a single lesson, it is that the too big to fail problem must be solved”
(Bernanke 2010). US Treasury Secretary Tim Geithner underscored that “the final area of reform (…) is perhaps
the most important, establishing new rules to constrain risk-taking by – and leverage in – the largest global
financial institutions (Geithner 2010). The Dodd-Frank Act of 2010 contains a host of provisions targeted at the
regulation and supervision of systemically-important financial institutions, including enhanced risk-based
capital, leverage, and liquidity standards and the requirement to prepare and maintain extensive rapid and
orderly dissolution plans. In the UK, Bank of England Governor Mervyn King emphasised in a recent interview
that “the concept of being too important to fail should have no place in a market economy” (King 2011). And
later this month, the Vickers Commission is slated to give its recommendations on the banking industry,
including its verdict on the merits of separating functions within the largest banks. Meanwhile, in the strongest
approach to date to deal with the too-big-to-fail problem, a committee of experts appointed by the Swiss Federal
Council (and including a representative from the Swiss National Bank) recommended that the total capital
requirement for Switzerland’s two largest banks (UBS and Credit Suisse) be set at 19% of their risk-weighted
assets, and that at least 10% of those assets must be held in the form of common equity (Committee of Experts
2010). If adopted, these capital requirements would be substantially more rigorous than the minimums

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recently agreed under Basel III (Goldstein 2011).

It is all the more remarkable then that the too-big-to-fail problem is barely present in substantial financial policy
debates and initiatives in most Continental European countries and at EU level, including the European
Commission. These jurisdictions have tended to favour the application of uniform regulations to financial
institutions irrespective of size and systemic importance, and have been generally reported as arguing against
specific policies targeted at systemically-important financial institutions in international bodies such as the
Basel Committee on Banking Supervision and the Financial Stability Board.

In a working paper that specifically analyses the transatlantic and intra-European variations of the too-big-to-
fail debate (or absence thereof); we identify four broad reasons for this contrast (Goldstein and Véron 2011):

 First and foremost, the much higher degree of concentration of banking markets makes the too-big-to-fail
problem more acute but also intrinsically more intractable in virtually all EU countries than it is in the US,
which may explain a strong reluctance to consider financial reform through the too-big-to-fail prism in the
first place; see Figure 1.

Figure 1. Aggregate assets to GDP of top three banks in selected countries (%)

Source: Bank for International Settlements

The higher assets-to-GDP ratios observed in Europe are mainly due to high banking sector concentration,
significant international expansion of some major banks, and business models that lead banks to retain many
assets on their balance sheet. Differences in accounting standards also play a role, but only to a much smaller
extent.

Of course, a large part of this transatlantic difference would disappear if the systemic importance of Europe’s
largest banks could be assessed against the size of the entire European economy, rather than national GDP.
Indeed, the ratios of consolidated assets to European GDP for Europe’s largest banks are similar to the ones that
can be observed in the US, or actually smaller when corrected for differences in accounting standards.
Unfortunately, this is not the correct scale of analysis as long as no EU-wide policy framework exists for bank
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crisis management and resolution. Such a framework has been advocated and discussed by the IMF and others
(see Chaka and Decreasing 2007; Fonteyn and al 2010; Véron 2007; Wall et al. 2011) but has not achieved
political consensus in the EU so far. Policy proposals are expected from the European Commission this year, but
they are unlikely to result in more than incremental progress from this perspective (European Commission
2011).

 Second, most European countries have displayed a general reluctance to let banks fail irrespective of their
size, so that the moral hazard problem is not confined to the largest institutions. An example of this (early
in the recent crisis) was the German government’s rescue of IKB and of other small-to-medium-sized
institutions at a significant cost to the taxpayer. By contrast, scores of US banks were allowed to fail since
the start of the crisis, most of them (including the very large case of Washington Mutual) through the
Federal Deposit Insurance Corporation’s receivership procedure that has no direct equivalent in many
European countries. This difference can partly be traced back to long-term historical legacies and attitudes
to risk and failure.

 Third, the interdependence between banking and political systems tends to be high in Continental Europe,
though difficult to assess quantitatively in comparative perspective. Significant segments of Europe’s
banking industry are constituted of non-commercial banks such as savings banks and mutual’s whose
governance often directly involves elected officials, as in Spain or Germany, as well as directly state-
controlled institutions such as Poland’s PKO BP or Germany’s Landesbanken. France’s tightly knit financial
establishment, which brings together both senior regulators and senior bank executives, is another
example of such interdependence. While the features vary markedly from one country, there is ample
scope for capture of the policy debate and process by the industry’s dominant players.

 Fourth, nationalism continues to play a significant role in shaping Europe’s financial policy choices which
tend to differentially protect and favour domestic “banking champions”, in spite of the non-discriminatory
principles enshrined in EU treaties and their increasingly assertive enforcement by the European
Commission. One result has been a near-generalised preference for intra-country bank mergers rather than
cross-border ones, especially in larger Western European countries. This has tended to exacerbate the too-
big-to-fail problem, both before the crisis and since its start.

The discussion on possible remedies to the too-big-to-fail problem is not a simple one, and no silver bullet is at
hand. There are different dimensions to the problem, each of which is associated with different policy options:
absolute bank size (which may be addressed with size caps or capital surcharges), market concentration
(which calls for competition policy or limits to market share), conglomeration (Glass-Steagall-like separations,
or the more recent Volcker rule), internationalisation (requirements for local funding and/or capitalisation), and
complexity (central clearing of transactions, living wills). Depending on the context, definitions of systemically-
important financial institutions generally rely on a mix of these criteria. But many gaps remain in our analytical
understanding of the too-big-to-fail problem. Furthermore, much of the available research tends to be focused
on the US case, whose features may not be easily extrapolated to non-US contexts (Demirgüç-Kunt and Huizinga
2011).

However, these analytical gaps should not be taken as an excuse to avoid an in-depth debate on the too-big-to-
fail problem in Europe; on the contrary. Moreover, given the potential risks to systemic stability, there is a case
for policy action even in the absence of analytical certainty. The very large too-big-to-fail problem faced by most
European countries should motivate a broad policy discussion on how to reform banking structures in Europe to

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mitigate it. The sooner the better.

References
Bernanke, Ben (2010), Testimony to the US Financial Crisis Inquiry Commission, September

BIS - Bank for International Settlements (2010), 80th Annual Report, June

Chaka, Martin, and Jörg Decreasing (2007), “The Case for a European Banking Charter”, IMF Working Paper
WP/07/73

Committee of Experts (2010), “Final Report of Committee of Experts for Limiting the Risks Posed by Large
Companies”, Swiss Financial Market Supervisory Authority and Swiss National Bank, October

Demirgüç-Kunt, Asli, and Harry Huizinga (2011), “Do we need big banks?”, VoxEU.org, 18 March.

European Commission (2011), “Technical Details of a Possible EU Framework for Bank Recovery and
Resolution”, DG MARKT working document, January

Fonteyn, Wim, Wouter Bossu, Luis Cortavarria-Checkley, Alessandro Giustiniani, Alessandro Gullo, Daniel Hardy,
and Sean Kerr (2010), “Crisis Management and Resolution for a European Banking System”, IMF Working Paper
WP/10/70, March

Geithner, Timothy (2010), “Rebuilding the American Financial System”, speech at NYU Stern School of Business,
August

Goldstein, Morris (2011), “Integrating Reform of Financial Regulation with Reform of the International Monetary
System”, Peterson Institute for International Economics Working Paper 11-5, February

Goldstein, Morris, and Nicolas Véron (2011), “Too Big To Fail: The Transatlantic Debate”, Peterson Institute for
International Economics Working Paper 11-2, January

Johnson, Simon (2009), “The Quiet Coup”, The Atlantic, May

King, Mervyn (2011), Interview in The Telegraph, March

Véron, Nicolas (2007), “Is Europe Ready For a Major Banking Crisis?”, Bruegel Policy Brief 2007/03, August

Wall, Larry, Maria Nieto, and David Mayes (2011), “Creating an EU-Level Supervisor for Cross-Border Banking
Groups: Issues Raised by the U.S. Experience with Dual Banking”, Federal Reserve Bank of Atlanta Working Paper
2011-06, March

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