Friday, March 29, 2013

Warren and Bernanke on Addressing Too Big to Fail in US Banking Sector

During a hearing of the Senate Banking Committee on February 26, Senator Elizabeth Warren interviewed Federal Reserve Chairman Ben Bernanke on the status of the US' largest banks. The central topic of the discussion was the "Too Big To Fail" issue. According to Warren, the TBTF  problem has actually gotten worse since the crisis began. Bernanke, agrees with the specification of TBTF problem. The plan apparently is to develop institutional mechanisms by which America's large systemic banks can be wound-down, should they fail. 

TBTF is toxic to the incentive structure underpinning a well-working financial market because it creates expectations that banks and other economic actors which are large enough to be systemic to a country's economy, and whose collapse would cause severe negative knock-on effects, making the consequences of bank failure disastrous to the economy as a whole. Market expectations are therefore, that the state would bail the banks out in case of failure, thereby dis-incentivizing prudent risk-management within the largest banks.

According to empirical research conducted by the Federal Reserve, banks are willing to to pay billions in added premiums associated with M&A costs in order to acquire TBTF status. What this should tell us is that American banks are definitely able to detect economic rents from becoming so large. 

This paper examines an important aspect of the “too-big-to-fail” (TBTF) policy employed by regulatory agencies in the United States. How much is it worth to become TBTF? How much has the TBTF status added to bank shareholders’ wealth? Using market and accounting data during the merger boom (1991-2004) when larger banks greatly expanded their size through mergers and acquisitions, we find that banking organizations are willing to pay an added premium for mergers that will put them over the asset sizes that are commonly viewed as the thresholds for being TBTF. We estimate at least $14 billion in added premiums for the nine merger deals that brought the organizations over $100 billion in total assets. These added premiums may reflect that perceived benefits of being TBTF and/or other potential benefits associated with size.
Max Berre is an economist at the EDHEC-Risk Institute (Ecole Des Hautes Etudes Commerciales du Nord) who has worked as a sovereign debt expert at the Inter-American Development Bank in Washington and has taught financial economics at Maastricht University in the Netherlands.