Comments on: The benefits of too big to fail A slice of lime in the soda Sun, 26 Oct 2014 19:05:02 +0000 hourly 1 By: OneEyedMan Tue, 06 Oct 2009 17:21:14 +0000 “The subsidy is free insurance and the right way to measure the cost to the government is the ex ante correct premium not the ex post losses that actually occur.”
FDIC insurance is not free. Banks pay premiums. It covers depositors against two eventualities. A bank run is costless to ensure against because the assets are worth more than liabilities if properly unwound. The government can just print the desired cash and then unwind the position. A bank failure from asset loss is also insured, but this insurance is costly to provide.

By: Thomas Spencer Tue, 06 Oct 2009 14:23:45 +0000 Another policy response is possible. Make it explicit which bank debts need to be guaranteed for financial system soundness and require TBTF banks pay the government an insurance premium to have those debts guaranteed.

Re OneEyedMan: The subsidy is free insurance and the right way to measure the cost to the government is the ex ante correct premium not the ex post losses that actually occur.

Re Dean Baker: Someone should ask why debt is cheaper than equity for banks. For TBTF banks some of it is the cost of this insurance. For banks that are clearly not TBTF how much of the cost advantage of debt over equity is due to the belief that if the bank does fail, the FDIC will arrange something that makes even the unguaranteed lenders/depositors whole? Unless there is some other important reason for debt being cheaper than equity for banks, it is not feasible to impose an appropriate cost on banks by raising capital requirements.

Imposing these insurance premiums is not going to solve all the prudential regulatory problems. The level of the premium has to be set somehow. I do not see how a market mechanism could be used. Moreover, there does not appear to be enough publicly available information to intelligently price default risk for a bank. This means that the size of premium will have to be set by some government employees (possibly including congress). Thus the premium will probably be set too low. Moreover, it is less bad for the premium to be too low than for it to be too high.

This comment is too long already, so what else to do will have to wait for another time.

By: Dean Baker Mon, 05 Oct 2009 21:17:53 +0000 Come on Felix,

just because we can’t get the number exactly right is that a reason not to try. Suppose the TBTF subsidy to Goldman is $1 billion and we raise their capital requirement by an amount that imposes an effective penalty of $1.2 billion. Is that worse than doing nothing and letting them effectively pocket the benefit, no questions asked?

I would agree that we don’t know exactly how big is too big to fail and that this would differ over time. Of course, that implies that the implicit subsidy would be lower also. While everyone may assume that BoA is too big too fail, we don’t know if that’s the case with the smallest of the large banks. That would suggest some sliding scale on capital requirements rather than a discrete break.

For some reason, the Obama administration has been pushing the discrete break view. That seems wrongheaded to me, unless the idea is that we will literally have an official policy that even a Capital One or other small big bank is TBTF.

By: OneEyedMan Mon, 05 Oct 2009 19:19:25 +0000 “At no point is the key logical step spelled out: if a big bank benefits by being too big to fail to the tune of say $1 billion a year, then there must be an equal and opposite $1 billion a year cost to taxpayers.”

This need not be so. The benefits of FDIC insurance to the banks is huge and over the long run may cost the government little. Similarly, if the benefits to the firm of the subsidy cause the miss-allocation of capital, the dead-weight loss must be added. A billion dollars of benefits to the firm may cost the economy far more than a billion when the distortions are included.