How Big is "Too Big to Fail," Exactly?

♠ Posted by Emmanuel in , at 5/18/2014 12:30:00 AM
Like any other international organization, the IMF portrays itself as a technocratic institution instead of a political one. In other words, they would like others to see themselves as economic experts offering solutions instead of as pawns in someone else's political machinations. There is, however, a fairly large literature on how the IMF lending is steered by American interests--see Thomas Oatley, Strom Thacker and James Vreeland among others. Apropos for the season, we got another reminder of IMF politicization as Managing Director Christine Lagarde bailed out on being the commencement speaker at Smith College after students protested the institution she represents.

For reasons I can no longer remember, I was put on the mailing list of the IMF. A recent message pointed me in the direction of a new staff publication (by Luc Laeven, Lev Ratnovski, and Hui Tong) concerning another contentious yet highly topical question: when exactly does a financial institution cross the threshold of becoming "too big to fail"? As the image taken above suggests, the largest of them have become even larger, although they have tapred off somewhat post-global financial crisis. There are undoubtedly policy implications for this question given the sheer size of money center banks in the US, UK or Switzerland. Or, even the various Landesbanks in Germany. Just think: if an IMF report said there was a threshold for becoming too big to fail (TBTF), you would expect all sorts of news reports touting the idea that big banks should be cut down to a certain size. Political pandemonium would ensue in any number of financial centers.

To be honest, I was hoping for such a TBTF threshold being identified. Instead we get a neither-here-nor-there answer. In other words, it's a Larry Summers response ("it depends") instead of a Nicolas Nassim Taleb one ("shrink 'em pronto). Anyway, to the paper's conclusion:
This paper contributes to the debate on the optimal size and scope of banks. It shows that large banks, on average, create more individual and systemic risk than smaller banks. The risks of large banks are especially high when they have insufficient capital, unstable funding, engage more in market-based activities, or are organizationally complex. This, taken together with the evidence from the literature that the size of banks is at least in part driven by too big-to-fail subsidies and empire-building incentives, suggests that today’s large banks might be too large from a social welfare perspective.

However, the literature also does not dismiss the case for the economies of scale in large banks (even though, in our reading of the literature, these economies are likely to be modest). As a result, “optimal” bank size is highly uncertain, and regulations that restrict outright bank size may be imprecise and difficult to implement. Optimal regulation of large banks should combine micro- and macro-prudential perspectives, and its tools may include capital surcharges on large banks (as in Basel III) and measures to reduce banks’ involvement in market-based activities and organizational complexity.
Again, it's exactly the contours of the Summers vs. Taleb debate, with the IMF (surprise!) coming down on the side of the arch-neoliberal Summers:
Summers told Taleb that he was for more capital, more liquidity, living wills for banks and procedures to wind them down. “What are you for?” he challenged. “I’m for punishment,” Taleb replied.
At any rate, the IMF conclusion is highly nuanced: It's not that banks are too big per se that they become too big to fail. Rather, it's when poorly governed banks reach a certain size that they are more of a systemic risk. At one end of the continuum, then, the IMF acknowledges that some banks have indeed become TBTF. At the other end, it also suggests that there is a "minimum economic size" below which banks become unable to adequately deal with risk since they have trouble surviving risk events of medium intensity. Instead of TBTF, call this "too small to succeed" (TSTS). In statistics-speak, it would have been nice to have been given point estimates--say, a certain bank constituting x percent of all deposits in the home country--for when a bank was TSTS on the low end or TBTF on the high end. In the absence of those, a confidence interval could have served a similar purpose.

Instead we get a cop-out calling for better regulation combined with an "I dunno" on optimal bank size. It's the same sort of bland prescription for "better education" you keep hearing in policy circles without quantifying how improvements in human capital will boost economic performance. Besides, for what reason is an international organization that prides itself on technocratic precision unwilling to venture that far? Re-read the first paragraph, and do not tell me the IMF is not playing politics once more in this example lest it get caught in a political maelstrom of its own making.

BTW: I have been linking to the IMF Direct blog since it came into existence and they have their own blog post there on this very topic. However, IMF Direct does not recognize this blog or any other political economy blog in its blogroll for that matter, seemingly reinforcing the economistic conceit that they are beyond the fray of politics--again, a technocratic pose. To complete its PR work--and I'd say the IMF does more of it in the blogosphere than the World Bank--the IMF should engage with its critics, especially those coming from more of a political economy perspective instead of an economics one. Having at least 83 posts on the IMF going by my cloud tag--more if you include Bretton Woods institutions--I doubt you'll find any (non-IMF) economics blogs that cover the institution in nearly as much depth from IMF reform to lending to Pakistan. Are you game enough, IMF Direct?

UPDATE: Recall that, of course, IMF Managing Director Christine Lagarde is a political science, not an economics, major.