Too big to fail has become a key issue in financial regulation. Indeed, in the recent crisis many institutions enjoyed subsidies precisely because they were deemed “too big to fail” by policymakers. The expectation that large institutions will be bailed out by taxpayers any time they get into trouble makes the job of regulators all the more difficult. 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—what economists call moral hazard. This makes reaching too-big-to-fail status a goal in itself for financial institutions, given the many implicit and explicit benefits governments are willing to extend to their large institutions. Hence, all the proposed legislation to tax away some of these benefits.
But could it be that some banks have actually become too big to save? Particularly for small countries or those suffering from deteriorating public finances, this is a valid question. The prime example is Iceland, where the liabilities of the overall banking system reached around 9 times GDP at the end of 2007, before a spectacular collapse of the banking system in 2008. By the end of 2008, the liabilities of publicly listed banks in Switzerland and the United Kingdom had reached 6.3 and 5.5 times their GDP, respectively.
In a recent paper  with Harry Huizinga, we try to see whether market valuation of banks is sensitive to government indebtedness and deficits. If countries are financially strapped, markets may doubt countries’ ability 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.
We investigate the impact of a country’s public finances, in the form of both government debt and deficits, on expected returns to bank shareholders as discounted in bank stock prices. We also distinguish between systemically important and smaller banks. In a parallel fashion, we consider the impact of government finances on expected losses on banks’ liabilities, as reflected in 5-year credit default swap (CDS) spreads. Specifically, we consider bank valuation over the 1991-2008 period, with 717 publicly listed banks in 34 countries in 2008, and CDS spreads over the 2001-2008 period, with 59 banks in 20 countries in 2008.
Overall, we find that while systemically large banks may benefit more compared to smaller banks from taking on more risk, they can also suffer from being in a country that runs large government 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 maximizes their implicit subsidy from the financial safety net. Such banks can increase shareholder value by downsizing or splitting up. For the overall sample, our results imply that the share prices of the average systemically important bank are discounted 22.3 percent because of systemic size, providing strong incentives to reduce bank size relative to the national economy. Indeed, consistent with this finding we also observe that a smaller proportion of banks are systemically important—relative to GDP—in 2008 than in the two previous years, which could reflect private incentives to downsize (Figure 1 - click on the image for a larger version).
Figure 1. Percentages of systemically large banks during 1991-2008
 This figure shows the percentages of banks with a liabilities-to-GDP ratio exceeding various thresholds. Specifically, Big0.1 displays the percentage of banks with a liabilities-to-GDP ratio exceeding 0.1. Big0.25 displays the percentage of banks with a liabilities-to-GDP ratio exceeding 0.25. Big0.5 displays the percentage of banks with a liabilities-to-GDP ratio exceeding 0.5. Big1.0 displays the percentage of banks with a liabilities-to-GDP ratio exceeding 1.0.
The problem of “too big to save” facing systemically large banks in fiscally strapped countries is likely to change the structure of the international banking system in the years to come. Banks in all financial systems will face pressure to deleverage in order to reduce risks for themselves and for the financial safety net. However, 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. Our evidence suggests that this should increase bank valuation. Indeed, in 2008 we see that very large banks had already deleveraged relative to their economy’s size. The downsizing that occurred in 2008 may thus in part be driven by a desire to increase stock market valuation in the face of the too-big-to-save effect, even if downsizing no doubt has also been forced by reduced capital on account of losses and difficulties in raising equity and other types of capital at a time of financial crisis.
There is an obvious policy interest in reducing bank size at least below the point where banks’ national contingent liabilities are so large that there are doubts about governments’ abilities to stabilize their banking system. This also at least partially explains the current proposals to limit bank size or tax systemically large banks. But even in the absence of additional regulation and taxation, the percentage of systematically large banks already declined in 2008 relative to the two previous years. This trend 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 serve to strengthen this trend.
Demirguc-Kunt, Asli and Harry Huizinga, “Are banks too big to fail or too big to save? International evidence from equity prices and CDS spreads ,” World Bank Policy Research Working Paper, 2010.