World Bank Systemically large banks may face private incentives to downsize In financial regulation, “too big to fail” has become a key issue.. They also distinguish between systemicall
Trang 1World Bank
Systemically large banks may face
private incentives to downsize
In 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
mak-ers The expectation that large
institu-tions will be bailed out by taxpayers
any time they get into trouble makes
the job of regulators all the more
diffi-cult 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
govern-ments are willing to extend to large
institutions make reaching
too-big-to-fail 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
li-abilities rose to about nine times GDP
at the end of 2007, before its
spec-tacular 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 Demirgüç-Kunt
and Huizinga investigate whether
market valuation of banks is sensitive
to government indebtedness and
defi-cits 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
Too Big to Fail or Too Big to Save?
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 govern-ment finances on expected losses on banks’ liabilities, as reflected in five-year credit default swap (CDS) spreads
Specifically, they consider bank valu-ation 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 gov-ernment 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 maxi-mizes their implicit subsidy from the financial safety net Such banks can increase shareholder value by downsiz-ing or splittdownsiz-ing up For the overall sam-ple, the results suggest that the share price of systemically important banks
is discounted 22.3 percent on average because of systemic size, providing
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 previ-ous years (figure 1)
The problem of “too big to save” facing systemically large banks in fis-cally strapped countries is likely to change the structure of the interna-tional 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 downsiz-ing should increase bank valuation The downsizing that occurred in 2008 thus may have been driven in part by a desire to increase stock market valua-tion 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 1 Systemically Large Banks as a Percentage of Publicly Listed Banks
in Selected Countries, 1991–2008
0
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
12 10 8 6 4 2
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.
Big0.1
Big1.0 Volume 5 l Number 1 l Fall 2010
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Interactions between Formal
and Informal Institutions
The reliability of the production
process is a physical channel
through which development can
influence institutions
economies informational and
con-tracting constraints make it more
difficult for enterprises to do
busi-ness 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
evi-dence of this from around the
devel-oping 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
insti-tutional interactions in which formal
and informal institutions coexist and
influence one another The authors
de-velop 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’
invest-ment in being “connected”; and a
for-mal mechanism, which acts through
legal enforcement (but can be
weak-ened by firms through bribes)
This theory makes two
contribu-tions First, it highlights the
impor-tance of market prices as a channel of
institutional interaction High
equilib-rium prices affect both the incentives
of firms to bribe because of the higher rents involved and the incentives of consumers to connect with one an-other to identify poorly performing firms At the same time, however, un-observed 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 middle-income countries), the higher the price must be relative to the actual costs of production This provides a new ex-planation 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 devel-opment can influence institutions: the reliability of the production process
An unreliable production process af-fects 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 con-nections in order to identify poorly performing firms
Preliminary evidence suggests that such a channel could play a signifi-cant role The authors use World Bank Investment Climate Survey data from six regions to study the determinants
of firms’ membership in business as-sociations (a proxy for informal con-nectedness) and of their perception
of corruption A firm is considered a member of a business association only
if it belongs to the association and rec-ognizes 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 com-ponents method, they construct a reli-ability index based on whether firms identify electricity shortages, transport, and skills as important constraints
Once country and sector character-istics 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 con-firms 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.
There is an obvious policy inter-est 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 cur-rent 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-big-to-save effect in fiscally constrained countries Additional regulation or taxation aimed at very large banks may strengthen this trend
Aslı Demirgüç-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.
(continued from page 3)
Too Big to Fail or Too Big to Save?