This post is the third in a series of twelve Liberty Street Economics posts on Large and Complex Banks.
Yesterday’s post presented evidence on a possible upside of very large banks, namely, lower costs. In today’s post, we focus on a possible downside, that is, whether investors in the primary bond market “discount†risk when they invest in bonds of the too-big-to-fail banks.
The idea that some firms are too big to fail seems to have first appeared in connection with the financial difficulties that Lockheed Corporation ran into in 1975. However, it was the demise of the Continental Illinois Bank in 1984 that provided solid supporting evidence for that idea. Continental Illinois, which was the seventh-largest bank by deposits, experienced deposit runs following news that it had incurred significant losses in its loan portfolio. Concerns that a failure of Continental Illinois would have significant adverse effects on other banks that had deposits with it led regulators to take the unprecedented move of assuring all of Continental’s depositors—large and small—that their money was fully protected. Subsequently, during the Congressional hearings on Continental Illinois, the Comptroller of the Currency indicated that the eleven largest banks in the United States were too big to fail.
The possibility that some banks are too big to fail has far-reaching implications. If investors believe certain banks are too big to fail, they’ll discount risk when providing them with funding, therefore encouraging these banks to take greater risks. Additionally, lower financing costs will induce large banks to behave more aggressively, decreasing charter values for competing banks and pushing them toward higher risk taking.
That possibility has triggered a large body of research. Researchers have attempted to detect evidence that market participants believe large banks are too big to fail by studying such things as bond spreads, deposit interest rates, credit-default-swap spreads, rating agencies’ support ratings, and bank merger premiums. Several studies in this literature find evidence supporting the idea that large banks are too big to fail and receive a funding subsidy as a result.
