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CORE Insights Too Big to Fail: Lessons from a Decade of Financial Sector Reforms

The authors of this Insight are:
Claudia M. Buch: Deutsche Bundesbank.
Angelica Dominguez-Cardoza: Deutsche Bundesbank, University of Kiel.
Jonathan Ward: Financial Stability Board.

31 May 2021

CORE Insights

Concepts in the insight are related to material in:

Unit 6, Unit 10, Unit 11, Unit 12, Unit 17, and Unit 22 of The Economy.

Unit 9, Unit 10, and Unit 12 of Economy, Society, and Public Policy.

Project 10 of Doing Economics.

Recommended reading before starting this Insight:

Sections 10.8 and 10.9 of The Economy (or Sections 10.4 and 10.5 of Economy, Society, and Public Policy) for an overview of how the banking system works.

Highlights

1 Introduction

global financial crisis
This began in 2007 with the collapse of house prices in the US, leading to the fall in prices of assets based on subprime mortgages and to widespread uncertainty about the solvency of banks in the US and Europe, which had borrowed to purchase such assets. The ramifications were felt around the world, as global trade was cut back sharply. Goverments and central banks responded aggressively with stabilization policies.
bank
A firm that creates money in the form of bank deposits in the process of supplying credit.

Prior to the global financial crisis of 2007–2008, the world’s financial system appeared to be functioning well—on the surface at least. Globally active banks had been expanding across borders, there was ample credit supply, growth was vibrant, volatility in markets was moderate, and interest rates were low.

Yet, as the first signals were appearing on the horizon that fortunes would turn, it was already too late: vulnerabilities had been building up underneath the surface, and these erupted with a force not seen in decades. Interest rates increased, market valuations plummeted, credit markets tightened, and instability in financial markets spilled over into the real economy.

investment bank
A financial institution that does not make loans or accept deposits, but instead carries out other banking activities such as helping companies and public sector institutions to issue securities, trading securities, foreign exchange, and all types of financial products; and advising companies on initial public offerings, mergers and acquisitions. Source: Bundesbank glossary.

In the early morning hours of 15 September 2008, Lehman Brothers, the fourth largest investment bank in the US, filed for bankruptcy after 164 years in business. The failure of Lehman triggered a global financial crisis, which created huge costs in terms of fiscal expenses, output losses, unemployment, and social tensions. A large amount of taxpayers’ money was spent to support banks that threatened to fail because they did not have enough equity to absorb their losses.

too big to fail
Said to be a characteristic of large banks, whose central importance in the economy ensures they will be saved by the government if they are in financial difficulty. The bank thus does not bear all the costs of its activities and is therefore likely to take bigger risks. See also: moral hazard.
bank bailout
The government buys an equity stake in a bank or makes some other intervention to prevent it from failing.
moral hazard
This term originated in the insurance industry to express the problem that insurers face, namely, the person with home insurance may take less care to avoid fires or other damages to his home, thereby increasing the risk above what it would be in absence of insurance. This term now refers to any situation in which one party to an interaction is deciding on an action that affects the profits or wellbeing of the other but which the affected party cannot control by means of a contract, often because the affected party does not have adequate information on the action. It is also referred to as the ‘hidden actions’ problem. See also: incomplete contract, too big to fail.

The disorderly events that followed the Lehman bankruptcy showed that if banks are too large or too connected to other parts of the financial system, or too ‘systemically important’, their failure can put the entire financial system at risk. In short, they may be too big to fail (TBTF). Faced with the prospect of the failure of such a bank, governments have, in the past, often felt obliged to step in to prevent it. Such bailouts are in fact a recurrent theme in the history of financial crises. This creates an important economic distortion, namely, moral hazard: a TBTF bank does not bear all the costs of its activities and is, therefore, likely to take too many risks.

The Lehman Brothers episode showed the dilemma that governments are facing when dealing with failing banks: both options—governments saving banks and governments letting banks fail—can carry dangers.

For details on the role that the banking system has played in historical financial crises, see Sections 17.2, 17.8 and 17.11 of The Economy.

systemically important financial institution (SIFI)
A financial institution is considered systemically important if its insolvency would have a serious impact on the functioning of the domestic financial system and have negative effects on the real economy. Systematically important banks are subject to stricter capital requirements and loss absorbency capacity than other banks. Global systemically important banks and domestic systemically important banks are further classifications of systemically important financial institutions. Source: Bundesbank glossary.

The global financial crisis revealed that the regulatory framework for banks was inadequate, and that banks were simply too fragile. Policymakers introduced a whole suite of regulatory reforms over the years that followed. These reforms included new regulations aimed specifically at systemically important banks. This was the first time that the TBTF problem had been explicitly tackled.

The new regulations are intended to make crises less likely and less costly: they reduce the probability of the failure of systemically important financial institutions and improve the way in which failing banks are dealt with, so that they do not have to be bailed out by governments.

This CORE Insight looks at what happened during the global financial crisis and how regulatory reforms since then aim to address the TBTF problem by:

2 The economics of TBTF

This section describes what happened during the global financial crisis and explains the economics of the TBTF problem.

What happened during the global financial crisis?

recession
The US National Bureau of Economic Research defines it as a period when output is declining. It is over once the economy begins to grow again. An alternative definition is a period when the level of output is below its normal level, even if the economy is growing. It is not over until output has grown enough to get back to normal. The latter definition has the problem that the ‘normal’ level is subjective.

Banks provide crucial services to the economy. They grant credit, provide savers with a place to keep their cash, and they facilitate payments (for more details on the day-to-day activities of banks, see Section 10.8 of The Economy). Interruption of these services is incredibly costly to the economy and its participants. When an individual bank fails, its customers may be unable to pay their bills, and its borrowers may have to repay their loans. That is costly for customers. But when the banking system as a whole gets into trouble, the consequences for the economy can be even more severe. Financial crises are strongly associated with recessions and unemployment.

financial stability
A state in which the financial system is always able to perform its economic functions. A stable financial system: (1) can absorb financial and real economic shocks, (2) can prevent contagion and feedback effects and (3) should neither cause nor excessively amplify a downturn in overall economic activity. Market participants can constantly adapt to evolving conditions or exit the market without jeopardising the functioning of the financial system. Macroprudential policy should be formulated such that it safeguards financial system stability. Source: Bundesbank glossary.

What causes financial crises? Financial stability is at risk if small shocks to a single bank can threaten the stability of the financial system and harm the real economy by disrupting the system’s core functions, as described above. Such contagion can arise not only where banks are too large or too connected to fail, but also where many banks are exposed to the same types of risks.

This is what happened during the global financial crisis. When Lehman Brothers filed for bankruptcy, it triggered the crisis, exposing vulnerabilities in the global financial system that reached far beyond the failure of an individual bank.

mortgage (or mortgage loan)
A loan contracted by households and businesses to purchase a property without paying the total value at one time. Over a period of many years, the borrower repays the loan, plus interest. The debt is secured by the property itself, referred to as collateral. See also: collateral.
liquidity
Persons and enterprises are liquid if they are able to fulfil their payment obligations at any time. Correspondingly, assets can be categorised according to their degree of liquidity or how readily they can be converted into cash. Cash is the most liquid asset. While financial assets like shares and bonds traded in the markets have a lower degree of liquidity than cash, they are much more liquid than real estate owing to the much lengthier process of selling property. Source: Bundesbank glossary
asset
Anything of value that is owned. See also: balance sheet.
net worth
Assets less liabilities. See also: balance sheet.
maturity transformation
The practice of borrowing money short-term and lending it long-term. For example, a bank accepts deposits, which it promises to repay at short notice or no notice, and makes long-term loans (which can be repaid over many years). Also known as: liquidity transformation.

Lehman, like other financial institutions, had suffered large losses on financial products linked to mortgages. In the fall of 2008, investors began to worry about whether Lehman could absorb the losses. Its share price fell and its short-term funding dried up. Because the market was not willing to roll over Lehman’s short-term debt, the bank faced a liquidity crisis: it did not have enough cash and liquid assets to pay its debts as they fell due. Even banks with positive net worth are vulnerable to this risk because they engage in maturity transformation. For further details, see Section 10.8 of The Economy.

For an account of the Lehman case, you can read the book The Fed and Lehman Brothers: Setting the Record Straight on a Financial Disaster, or listen to this podcast, in which the author, Laurence Ball, discusses the book’s main ideas.

For further details on the global financial crisis, see Sections 17.8, 17.9, 17.10 and 17.11 of The Economy. To learn more about the risks in the mortgage market and implications for financial stability during the global financial crisis, you can read the article ‘Systemic Risk in the Financial Sector: An Analysis of the Subprime-Mortgage Financial Crisis’ by Martin Hellwig, or the book Fault Lines: How Hidden Fractures Still Threaten the World Economy by Raghuram Rajan.

At the time, Lehman was not considered to be TBTF. It was large, but not very large: it was the fourth-largest investment bank in the US. The bank therefore went into regular bankruptcy proceedings in the jurisdictions in which it operated. On the day it failed, Lehman reported assets of $639 billion. (By way of comparison, JPMorgan Chase’s assets were over $2 trillion.) Yet the Lehman Brothers’ insolvency triggered a financial crisis. It turned out to be ‘too connected to fail’ or ‘too complex to fail’ in an orderly manner. Banks are often highly interconnected through their lending and trading activities. Moreover, if they become exposed to similar kinds of risk, such as the mortgage-linked financial products that triggered Lehman’s losses, they may also become indirectly connected and hence vulnerable to contagion.

interbank market
A market in which banks borrow to and lend from each other.
solvent
A firm or individual for which net worth is positive or zero. For example, a bank whose assets are more than its liabilities (what it owes). See also: insolvent.

Therefore, when Lehman filed for bankruptcy, market participants suspected that other banks could be in trouble as well. Banks became reluctant to lend to each other in the interbank market. The interbank market, however, is a crucial channel through which banks receive funding: many of them roll over their short-term debt every night, as Lehman did. The result was a ‘liquidity run’: even sufficiently capitalized, solvent banks were at risk of not receiving short-term funding.

fire sale
The sale of something at a very low price because of the seller’s urgent need for money.
positive feedback (process)
A process whereby some initial change sets in motion a process that magnifies the initial change.

Banks tried to generate cash by selling assets. While this was a rational choice for each bank, it was disastrous for the system. With all banks trying to offload similar assets as fast as they could, asset prices fell sharply, which generated further losses for the banks. The fire sales of assets created a positive feedback process in the financial system, and lending to the real economy declined. (Section 17.9 of The Economy explains how feedback processes work in asset markets.)

For more details on how markets determine the value of financial assets, see Sections 11.5 and 11.6 of The Economy (or Sections 10.8 and 10.9 of Economy, Society, and Public Policy).

insolvent
An entity is insolvent if the value of its assets is less than the value of its liabilities. See also: solvent.
capital (firms and banks)
The money that a firm has obtained from its shareholders and any profit that it has made and not paid out.

Banks did not have enough capital to absorb the large losses. Relative to total assets, the systemically important banks had capital of only about 4% of total assets in 2007. This meant that if their assets were to fall in value by only 4%, capital would be wiped out, making them insolvent.

Hence, the Lehman failure triggered large-scale losses and disruptions in the financial system, and that eroded confidence in other financial institutions, threatening their failure. And not just one country, but the global financial system was affected.

bank run
A situation in which depositors withdraw funds from a bank because they fear that it may go bankrupt and not honour its liabilities (that is, not repay the funds owed to depositors).

Governments were therefore compelled to act to prevent widespread bank failures. They did so by bailing out the banks, assuming losses that would, in the event of bankruptcy, have fallen on the banks’ shareholders and creditors such as pension funds and other financial institutions. Generally, there are several ways to support a failing bank. One way is to inject capital in exchange for an equity stake. The government may even have to inject so much capital that it ends up nationalizing the bank. Another common way is to guarantee some or all of the bank’s liabilities, such as deposits, in order to prevent a run on the bank.

Government support prevented losses from spreading further throughout the financial system, and it mitigated the harm that the credit contractions did to the real economy. But much damage had already been done, and the crisis indeed turned out to be very costly:

For details on government bailouts during the global financial crisis, see the reports by the Congressional Budget Office and the Congressional Oversight Panel for the US, and the European Commission. Researchers Laeven and Valencia and the Financial Stability Board provide information on systemically important institutions that failed or received official support.

Moral hazard and systemic risk externalities

external effect
A positive or negative effect of a production, consumption, or other economic decision on another person or people that is not specified as a benefit or liability in a contract. It is called an external effect because the effect in question is outside the contract. Also known as: externality. See also: incomplete contract, market failure.

The events of 2008 show how costly it can be if moral hazard leads banks to take on excessive risk and if external effects for the stability of the financial system are not internalized. (See Section 12.7 of The Economy for an explanation of how moral hazard and external effects operate in credit markets.)

Other financial entities such as insurance companies and pension funds play very important roles in the financial system, too, and their relative importance is increasing. Indeed, non-bank financial intermediaries now own nearly half of global financial assets. But the focus of this CORE Insight is on banks, because of their prominent role in the global financial crisis and the subsequent reforms.

Figure 1 The economics of TBTF.

Figure 1 takes a closer look at how decisions taken by banks, governments, and market participants interact to lead to a TBTF problem (FSB 2021, p. 12):

balance sheet
A record of the assets, liabilities, and net worth of an economic actor such as a household, bank, firm, or government.
funding structure of bank
Every bank has two sources of funds: capital and debt. Debt is the money that it has borrowed from its creditors and will have to pay back. Debt includes among other things deposits from customers, debt securities issued and loans taken out by the bank. Source: ECB.
resolution
The process of closing or restructuring a bank without interrupting its critical economic functions. Bank shareholders and some or all of the bank’s creditors bear the losses, instead of taxpayers. One approach to resolution is bail-in. See also: bail-in.
funding cost advantages
The difference between a financial institution’s actual funding cost and its hypothetical funding costs if it were not benefiting from an implicit guarantee. Funding cost advantages are a measure of the implicit government subsidy accruing to systemically important banks and thus the expected bailout that bondholders expect to receive. See also: implicit guarantees.
market failure
When markets allocate resources in a Pareto-inefficient way. Examples of market failure are moral hazard, external effects and ‘hidden actions’ problem. See also: external effects, hidden actions (problems of) and moral hazard
implicit guarantees
Where market participants believe that the government would support a bank in case of its financial distress to avoid feedback effects with the real economy, the bank and its creditors are said to enjoy an implicit guarantee. See also: funding cost advantages.

When there is an implicit promise of government support if a problem arises, and investors do not require full compensation for risk, this provides incentives for managers and owners of financial institutions to take on more risk than is optimal from a social point of view. Thus, the decisions of banks, governments and investors all affect each other, as illustrated in Figure 1. At the bank level, one might also observe higher wages and executive compensation, together with higher profits, encouraging risk-taking at individual level.

systemic risk (in the financial system)
The risk that problems encountered by one or more market participants, and/or the adjustments they make in response to those problems, will impair the functioning of the financial system. Source: Bundesbank glossary.

Through these channels, moral hazard also affects the overall resilience of the financial system and the provision of finance. If banks experience a negative shock to capital, their short-run response can be to curb lending or to sell assets. A reduction in lending and a fire-sale feedback loop, as described above, can amplify the adverse effects on the financial system and the real economy. These systemic risk externalities are not internalized by individual banks.

Financial institutions that do not benefit from a TBTF subsidy will also be affected: systemically important financial institutions may increase their market shares at the expense of financial institutions that do not enjoy implicit funding subsidies. Market structures and competition will thus be distorted.

Section 12.1 in The Economy explains what external effects are, and Section 12.7 explains why they are present in credit markets. Section 17.8 in The Economy discusses the ideas of the economist Hyman Minsky about the financial system’s contribution to macroeconomic fluctuations.

In sum, banks that are TBTF give rise to a systemic risk externality: their probability of failure increases beyond socially optimal levels because managers and owners do not have to carry the full costs associated with their decisions. They reap potential benefits but only partially bear the risks, which leads to moral hazard. Banks’ incentive schemes may also promote such behaviour if managerial compensation is tied to risk-taking in a way that does not take external effects into account.

Question 1 Choose the correct answer(s)

Which of the following situations threaten the functioning of the financial system?

  • an uncontrolled and unmonitored build-up of systemic risk in a financial institution
  • a small investor such as a private household making speculative investments with borrowed money
  • a large financial institution, which is the main short-term lender for several small banks, suffering a sudden tightening of liquidity provided through the interbank market
  • a strong expectation from market participants that authorities would intervene in case of financial distress to avoid feedback effects with the real economy
  • Unmonitored and unregulated build-up of systemic risk can lead to an improper functioning of market mechanisms to price in this risk. Financial institutions other than banks can have an impact on the financial system they are interconnected through, for example, transactions in securities markets.
  • Potential failure of a small investor is unlikely to cause contagion towards other institutions.
  • Without sustainable funding, the financial institution will have to cut its lending and therefore jeopardize the funding of the other small banks that rely on it. The financial trouble from a single institution has now spread to other banks.
  • This implicit guarantee causes market participants to fail to price in risk appropriately. Financial institutions are now subject to moral hazard: they may take excessive risks because they do not suffer the consequence of these risks.

Question 2 Choose the correct answer(s)

Which of the following makes financial crises costly for society?

  • reduced access to credit or increased cost of credit for non-financial firms
  • higher fiscal spending for social insurance as unemployment increases
  • higher fiscal spending to support failing banks
  • new regulations that impose costs on financial institutions
  • Financial crises often affect many other industries that rely on financial services to produce and keep their workers employed.
  • The associated rise in unemployment puts additional pressure on social insurance which has to be funded by the taxpayer.
  • To avoid a collapse of the financial system, and in the absence of appropriate regulation, failing banks often need to be supported by governments and therefore ultimately by the taxpayer.
  • When well-designed, these regulations price in external effects of systemic risk. Hence, new regulations are not a cost to society, although the likely side effects of regulations need to be taken into account when designing them.

Exercise 1 Transformation of bank balance sheet composition

Answer the following questions using the bank balance sheet in Figure 10.16 (in Unit 10 of The Economy, reproduced below) and the additional balance sheets provided below.

collateral
An asset that a borrower pledges to a lender as a security for a loan. If the borrower is not able to make the loan payments as promised, the lender becomes the owner of the asset.
Assets 2006 2013 2020
Cash reserve balances at the central bank 7,345 45,687 191,127
Wholesale reverse repo lending 174,090 186,779 248,014
Loans (for example mortgages) 313,226 430,411 342,632
Fixed assets (for example buildings, equipment) 2,492 4,216 4,032
Trading portfolio assets 177,867 133,069 127,950
Derivative financial instruments 138,353 324,335 302,446
Other assets 183,414 187,770 133,314
Total assets 996,787 1,312,267 1,349,515
Liabilities      
Deposits 336,316 482,736 481,036
Wholesale repo borrowing secured with collateral 136,956 196,748 276,968
Unsecured borrowing 111,137 86,693 75,796
Trading portfolio liabilities 71,874 53,464 47,405
Derivative financial instruments 140,697 320,634 300,775
Other liabilities 172,417 108,043 100,652
Total liabilities 969,397 1,248,318 1,282,632
Net worth      
Equity 27,930 63,949 66,883

Figure 2 Barclays Bank’s published balance sheets for 2006, 2013, and 2020 in £m.

Barclays Bank PLC Annual Report 2013 and 2020.

leverage ratio (for banks or households)
The value of assets divided by the equity stake in those assets.
  1. Describe how liabilities and assets have changed over time, both in terms of scale (value) and structure (type of liabilities or assets). What have been the major changes since 2006?
  2. Comment on what happened to Barclays Bank’s liquidity over time (no calculations required). Is this bank less or more resilient to liquidity shocks in 2020 compared to 2006 and 2013?
  3. Assume that the capital ratio equals net worth (equity) divided by total assets. How has the capital ratio changed over time? Explain whether or not it is possible to calculate the leverage ratio if you only know the capital ratio.
  4. Describe (without doing any calculations) how the capital ratio of the bank would be affected by a change in the prices of financial assets.

3 The economics of how to mitigate TBTF

Figure 1 (Section 2) already gives a clue of how to design policies to mitigate the TBTF problem: by reducing risks and by improving the ability of authorities to deal with failures once they have happened. The better governments can deal with failing banks without bailing them out, the lower are banks’ funding cost advantages, the better are private and public interests aligned, and the lower the costs for the taxpayer.

In fact, after the global financial crisis, all these policies were introduced (Section 4). Let’s see how these policies work.

Capital requirements and supervision

The first element of reforms addressing the TBTF problem is to reduce the probability that a bank fails—the ‘probability of default’—causing losses to the rest of the financial system and the wider economy. Of course, the business model of banks is to make risky loans, so all banks manage the risk that some of their loans are not repaid. But in the absence of regulation, they do not manage the risks that they impose on others. The moral hazard problem that causes systemic risk externalities can lead to situations in which banks take decisions that increase their profits, but are not in the interest of taxpayers and depositors. They may take too much risk, knowing that if it goes wrong, others will pay the price.

capital requirements
A rule requiring banks to meet or exceed a certain capital ratio. The ratio is calculated by dividing available capital by risk-weighted assets. This rule is necessary because banks take risks. For example, there is the risk of a borrower being unable to repay their loan (credit default risk) or financial market prices becoming unfavourable for the bank (market risk). In order to protect its creditors, the bank therefore needs sufficient equity capital to absorb any losses arising from this risk. Source: Bundesbank glossary. See also: leverage ratio (for banks or households).

Taxpayers and depositors thus delegate power to regulate and supervise banks to public authorities who have, in essence, the role of aligning private and social incentives and making sure that banks do not take on excessive risks. Capital requirements are an important regulatory instrument for banks.1 Minimum capital requirements provide buffers against unexpected losses, and they incentivize banks to properly manage risks by requiring shareholders to absorb losses.

principal–agent relationship
This relationship exists when one party (the principal) would like another party (the agent) to act in some way, or have some attribute that is in the interest of the principal, and that cannot be enforced or guaranteed in a binding contract. See also: incomplete contract. Also known as: principal–agent problem.
incomplete contract
A contract that does not specify, in an enforceable way, every aspect of the exchange that affects the interests of parties to the exchange (or of others).

‘Too big to fail’ is a principal-agent problem, where the government is the principal and the bank is the agent. As in all principal-agent problems, there is (a) a conflict of interest, in this case between the government and the bank, concerning (b) a choice by the bank that is not subject to a complete contract, namely the level of risk taken by the bank. The contract is incomplete because the government cannot impose its choice of business strategies on the bank. But it can raise the cost of risk-taking by the bank by imposing capital requirements and thereby reduce the probability of failure.

Section 6.10 of The Economy (Section 6.15 of Economy, Society, and Public Policy) explains why principal-agent problems arise, and Section 10.12 of The Economy (Section 9.10 of Economy, Society, and Public Policy) discusses principal-agent problems in the context of credit markets.

Recall the balance sheet of a typical bank, as discussed in Section 10.7 of The Economy. The bank’s equity measures its net worth, typically a small percentage of a bank’s balance sheet. From the perspective of the bank’s creditors and the financial system, equity is a buffer: it absorbs losses until it is depleted. That is why bank regulators intervene to make sure that there are sufficiently large buffers to actually absorb losses.

Prior to the global financial crisis, however, bank capital regulation did not differentiate between banks that are systemically important and those that are not. In other words, it ignored the systemic risk externalities of large and complex banks. Hence, banks had incentives to become TBTF and to engage in excessive risk taking.

If large and systemically important financial institutions are required to meet additional capital requirements, this reduces their incentives to grow inefficiently large and encourages them to take the true social costs of their risk-taking into account. Higher capital in individual banks also makes the financial system more stable: if a bank has more capital to absorb losses, this reduces the need to reduce their supply of lending if they experience losses. Deleveraging, that is, the shrinking of banks’ balance sheets in times of crisis, is mitigated, which is good for the real economy.

Pigouvian tax
A tax levied on activities that generate negative external effects so as to correct an inefficient market outcome. See also: external effect.

Capital requirements that internalize negative external effects of banks being TBTF are very similar to a Pigouvian tax, which internalizes environmental external effects, while raising costs for the firms affected. The withdrawal of implicit TBTF subsidies results, similarly, in an internalization of external effects. It works through an increase in banks’ funding costs. Like the introduction of a pollution emission tax, an increase in funding costs will be perceived as a cost by private market participants. But at the same time, external effects and costs of financial crises to the taxpayer decline. The difference is that tax increases can be directly observed. Funding subsidies for TBTF banks are implicit, in other words, we cannot directly observe their withdrawal. (We will return to the measurement issue in Section 5.)

To learn more about Pigouvian taxes and how they work mathematically, read Section 12.3 and Leibniz 12.3.1 of The Economy. The Great Economist box in Section 12.3 describes the life of Arthur Pigou, the inventor of the Pigouvian tax.

microprudential supervision
The supervision of individual institutions, which mainly involves supervisors overseeing compliance with qualitative (e.g. risk management) and quantitative (e.g. capital) requirements. Source: Bundesbank glossary. See also: capital requirements.

In addition, institutions that monitor and mitigate systemic risk are needed. Prior to the global financial crisis, central banks were mainly in charge of ensuring price stability, and microprudential supervisors were in charge of ensuring the safety and soundness of individual financial institutions. But no designated public authority was typically in charge of monitoring whether systemic risk in the financial system was building up, or doing something about it.

macroprudential policy
Measures that intend to ensure that market participants take a cautious approach to risks that could affect the whole financial system (systemic risks). Prudential policies relate to actions that promote sound practices and limit risk-taking. The prefix ‘macro’ indicates that the policies or actions relate to the whole or significant parts of the financial system rather than individual financial institutions. Source: ECB – Explainers. See also: systemic risk.

Hence, macroprudential regulation and surveillance was created as a new policy area. The term may not sound very intuitive, but it is really about ensuring that the financial system can function, even in times of stress. As we have seen in Section 2, a functioning financial system intermediates between savers and investors, funds investment projects, and ensures the smooth running of the payments system at all times.

Resolution regimes

Higher capital buffers increase the resilience of banks while they are solvent and operating as a going concern. The second element of the policy reforms was to deal better with the failure of a bank (in other words, as a ‘gone concern’). Bank regulation is not intended to prevent banks from taking risks, as that is a basic feature of the business of banking, and it is inevitable that some banks will fail. Indeed, in a competitive market, entry and exit are desirable to stimulate innovation. What is important is that the failure of a bank can be managed in an orderly fashion so that its critical functions are preserved and losses to the economy are minimized.

Moreover, if a crisis strikes, governments need to be prepared to handle the failure of a systemically important bank. When a non-financial firm or a smaller bank is insolvent, it is wound up through bankruptcy proceedings. We saw in Section 1 that the bankruptcy of Lehman triggered a global financial crisis. Hence, a special mechanism is needed to deal with large or highly interconnected banks that are failing.

The process of closing or restructuring a bank without interrupting its critical economic functions is called resolution. Banks can be resolved in a number of ways, but in all approaches, losses are imposed not on taxpayers or bank customers but on bank shareholders and on some or all creditors.

bail-in
A bail-in resolution is a way of allocating losses to a bank’s shareholders and potentially to some of its creditors. The bail-in procedure follows a legal order of priorities in terms of liability (‘liability cascade’). The first step is to write down the bank’s equity capital to reflect the losses incurred. If these funds are insufficient, other liabilities, such as bonds, are written down or converted into equity.

One approach to resolution is bail-in. The bail-in procedure follows a ‘liability cascade’. The first step is to write down the bank’s equity to reflect the losses incurred. If these funds are insufficient, others bear the losses. This step takes place when liabilities, such as bonds, are written down (have their value reduced) or converted into equity. Among others bearing losses are also those depositors whose deposits are not covered by deposit insurance. In the final step, the deposit insurance scheme (run by financial authorities) may absorb some losses in lieu of insured depositors. For example, in the European Union, private deposits of less than €100,000 are covered by deposit insurance and will not be used in a bail-in. But bailing in other depositors, which may include charities and local public authorities, can still be a politically sensitive decision. That’s why having liabilities that absorb losses before depositors do—this is called ‘loss absorbing capacity’ or LAC—is important.

The next section will explain that post-crisis reforms have introduced a type of liability that is explicitly at risk of being bailed in should there be a bank failure.

Question 3 Choose the correct answer(s)

Which of the following policies would effectively manage the moral hazard cost associated with the expectation of implicit government subsidies?

  • increasing the loss absorbency of financial institutions
  • requiring every financial institution to self-evaluate their moral hazard and publish an annual moral hazard cost report
  • increasing taxes on financial institutions in order to increase their funding costs
  • requiring a detailed resolution plan from relevant financial institutions, which includes information on how potential losses would be covered
  • Increasing capital forces financial institutions to have more ‘skin in the game’: if the bank loses money, investors pay more of the losses with their own money, which lowers incentives for excessive risk-taking.
  • A self-evaluation of moral hazard is unlikely to be an accurate description or to change behaviour in a significant way. That is because the underlying incentives that gave rise to moral hazard remain unchanged.
  • The instruments that are used to internalize negative external effects, such as higher capital requirements, indirectly ensure that markets price risks better. By contrast, an increased tax on bank profits would not reduce the incentives of TBTF banks to take on too much risk.
  • An orderly resolution plan (‘living will’) reduces the need for a government bailout, thereby forcing investors to assess and price risk.

Question 4 Choose the correct answer(s)

Which of the following statements best describes what happen if there is a bail-in resolution regime in place?

  • only equity owners lose money if a bank faces losses
  • deposit insurance is paid to private retail depositors
  • losses may be allocated to the bank’s shareholders and bondholders
  • the government spends public money to cover a bank’s losses
  • While equity capital is the first line of defence against losses, it also absorbs losses even without a resolution process.
  • The deposit insurance scheme means that private deposits up to a specified amount will not be used in a bail-in. However, deposits are the last step in the liability cascade so are not a key feature of a bail-in.
  • Capital and liabilities are among the sources of loss absorbing capacity.
  • If governments cover losses of banks instead of imposing losses on creditors, this is called a bailout.

4 Policy measures implemented after the crisis

Capital requirements and resolution regimes were at the core of the regulatory reforms that were implemented after the global financial crisis. This section describes what was actually decided and how policies are evaluated. We start with an overview of the institutions in charge.

The institutional framework

Clearly, TBTF is a problem that cannot be solved at the national level. The failure of Lehman Brothers had global repercussions and contributed to triggering a global recession. This does not necessarily mean that we need a global authority that regulates all global banks. Instead, financial regulation is closely coordinated internationally while leaving national (or European or other economic and political unions) authorities in charge of implementing global standards and supervising banks. This is partly because many financial stability risks can arise from specific features of the domestic financial system. Furthermore, many of the costs of financial crisis—in terms of output losses, social costs, and fiscal expenses—occur at the national level.

G20
A group of 20 jurisdictions with similar economic interests that meet in informal advisory sessions to make joint decisions and share initiatives. The members of the G20 are Canada, France, Germany, Italy, Japan, the UK, the US, the EU, Argentina, Australia, Brazil, China, India, Indonesia, Mexico, Russia, Saudi Arabia, South Africa, South Korea and Turkey. The G20 represents around two-thirds of the global population and 80% of world GDP. Source: Bundesbank glossary.

Yet domestic policymakers might act too late when risks are building up, and they may not take into account cross-border spillovers. At the international level, risks to financial stability are thus monitored, and policy principles are decided that are then implemented at the national level. This is the role of the Financial Stability Board (FSB), created in April 2009, in which all G20 countries are represented. It promotes international financial stability by coordinating national and international authorities. Around the FSB table, central banks, ministries of finance, bank regulators and market regulators agree on international standards or give guidance. At the national level, these standards need to be drafted into national law, and national institutions are in charge of implementing these policies.

Another important institution is the Basel Committee on Banking Supervision (BCBS), which was established in 1974. It is the main global standard setter for the prudential regulation of banks. The Committee typically meets in Basel, Switzerland, hence the name.

European Systemic Risk Board (ESRB)
The (ESRB) is an EU body which is responsible for overseeing the financial system in the EU as a whole and for the timely identification of systemic risk (macroprudential oversight). The ESRB can issue warnings, making such warnings public where appropriate, and make recommendations. Based at the European Central Bank (ECB), the ESRB comprises representatives from the ECB, national central banks, supervisory authorities and the European Commission. Source: Bundesbank glossary.

In the European Union, there is also an important role in risk monitoring and the co-ordination of policy implementation at the supranational level, because of the close degree of financial integration of member countries. The European Systemic Risk Board (ESRB) is one such institution and plays an important role in coordinating macroprudential policies across countries.

The reforms

Basel Committee on Banking Supervision
An international group that develops international standards for supervising and regulating the banking sector. The most important regulatory frameworks are known as Basel II and Basel III. Representatives of central banks and supervisory authorities from different countries are members of the Basel Committee. The committee is located at the Bank for International Settlements (BIS) in Basel. Source: Bundesbank glossary.

In 2009, G20 leaders called on the Financial Stability Board to propose measures to address the systemic and moral hazard risks associated with systemically important financial institutions. Subsequently, the FSB proposed a policy framework for reducing the moral hazard posed by systemically important banks.2 3 This was complementary to a package of banking reforms which applies to all internationally-active banks. This package, introduced by the Basel Committee on Banking Supervision in 2010, is called Basel III, because it is the third of a series of reforms in banking regulation.

You can read more about the FSB’s policy recommendations in their 2010 report ‘Reducing the Moral Hazard Posed by Systemically Important Financial Institutions’ and their 2011 report ‘Policy Measures to Address Systemically Important Financial Institutions’.

A global minimum capital requirement was introduced for the first time in 1988 with the Basel Accord. In Exercise 1, you calculated a capital ratio and leverage ratio that did not take account of the varying risk of assets on the balance sheet. The Basel Accord tried to account for the fact that some assets are riskier than others. Each type of asset was assigned a risk weight: 20% for loans to banks and 100% for loans to corporates, for example. The sum of its assets multiplied by their risk weights is called its risk-weighted assets (RWAs), and the capital requirement was a risk-weighted capital requirement. Specifically, the 1988 Accord required internationally-active banks to fund themselves with capital of at least 8% of their risk-weighted assets. The 2010 Basel III package narrowed the definition of capital and increased minimum capital ratios. It added a second type of minimum capital requirement—a leverage ratio—as a supplementary measure. (See Unit 10.10 of The Economy for an explanation of how leverage is measured.)

Systemically important banks have to meet additional requirements. Since 2011, the FSB has, for this purpose, published an annual list of global systemically important banks (G-SIBs). In 2019, 30 G-SIBs were identified (see Figure 3). The identification of G-SIBs is based on an assessment methodology produced by the Basel Committee. This methodology uses bank size, interconnectedness, availability of substitutes for its services, international activity and complexity as inputs to calculate a G-SIB score, which is a measure of a bank’s systemic importance. Hence, in defining which financial institutions are ‘systemically important’, size is relevant, but it is not the only factor. Instead, the approach also considers whether a bank is highly connected with other parts of the financial system or whether it provides critical financial services.

In 2012, the G-SIB framework was extended to cover domestic systemically important banks (D-SIBs). While not all D-SIBs are systemically important from a global perspective, their failure could cause harm to their domestic economy, with the potential to generate contagion effects across borders. By 2018, 132 banks had been designated by the national authorities as D-SIBs in FSB jurisdictions (see Figure 3).

Figure 3 Number of SIBs by jurisdiction as at end 2018.
Note: The total number of banks in each country is shown below the country label. China (CN) and the US have not designated D-SIBs.

FSB 2021
Country codes: DE = Germany, RU = Russia, ID = Indonesia, JP = Japan, SG = Singapore, CA = Canada, TR = Turkey, MX = Mexico, FR = France, HK = Hong Kong, ZA = South Africa, SA = Saudi Arabia, CH = Switzerland, BR = Brazil, NL = the Netherlands, ES = Spain, AR = Argentina, KR = South Korea, CN = China, IT = Italy, SE = Sweden, AU = Australia, IN = India.

It is not the purpose of the TBTF reforms to ensure that there are no systemically important banks. Rather, the reforms aim to reduce the negative external effects from the decisions of systemically important banks so that they are not TBTF. The FSB policy framework has the following elements:

total loss absorbing capacity (TLAC)
A regulatory standard that requires global systemically important banks (G-SIBs) to have sufficient financial instruments available during resolution to absorb losses and enable them to be recapitalized, so they can continue performing their critical functions while the resolution process is ongoing. The objective of TLAC is to have an orderly resolution by making debt/equity holders absorb losses (enabling a ‘bail-in’) instead of using public funds (conducting a ‘bailout’). Source: BIS - TLAC – Executive Summary. See also: bail-in, bank bailout, resolution, systemically important financial institution.

These policies are in line with measures based on economic principles, as discussed in Section 3. The new regulations enhance the resilience of banks through capital surcharges, and they increase the loss absorbing capacity for banks that are failing.

Cycle for the evaluation of the reforms

Have these reforms worked? Have they achieved their intended effects, and what could be possible unintended consequences? To answer these questions, a structured framework for the evaluation of reforms is useful (a ‘policy evaluation cycle’). Such a policy evaluation cycle involves four steps:

Financial Stability Board (FSB)
An international institution that coordinates the work of national financial supervisory authorities and international standard-setting bodies in the financial sector. It consists of representatives from central banks, finance ministries, supervisory authorities and international organisations. The FSB’s secretariat is located at the Bank for International Settlements. The FSB is the successor of the Financial Stability Forum, which was set up by G7 countries in 1999 and underwent reforms (including renaming) in 2009. Source: Bundesbank glossary.
shadow banks
The Financial Stability Board (FSB) defines shadow banks as financial market players that engage in activities and perform functions similar to those of banks (particularly in the lending process) but are not banks themselves, meaning that they are not subject to banking regulation. Shadow banks do not necessarily belong to the semi-legal or illegal ‘shadow economy’. Regulated credit institutions can outsource operations to specialised shadow banks and thus – perfectly legally – circumvent regulatory measures. Source: Bundesbank glossary.

For more details on the policy cycle of macroprudential policies, read the paper ‘Evaluating macroprudential policies’ or the FSB’s framework for policy evaluation.

Question 5 Choose the correct answer(s)

What is the purpose of ex ante policy evaluation?

  • making sure that analytical models developed in academia are used by policymakers
  • making sure that the planned regulation contributes to reaching the policy objective without too many side effects
  • providing policymakers with estimates of the costs and benefits of the planned regulation
  • making sure that regulations do not affect the profitability of financial institutions
  • An analytical model might be a tool for the evaluation, but it is not its purpose.
  • The policymakers want to ensure that their policies have their intended effect.
  • Ex ante policy evaluation cannot give precise numbers on the effects of reforms, but it aims to assess the costs and benefits quantitatively and qualitatively.
  • Evaluations assess the effectiveness of policies. Profitability might be an indicator to consider, but it is not an objective of the reforms.

Question 6 Choose the correct answer(s)

What is the purpose of ex post policy evaluation?

  • checking whether the objectives of the policy changes have been defined correctly
  • measuring whether the intended effects of financial regulations have been delivered
  • measuring the unintended costs of regulations for the financial services industry
  • making sure that the intensity of regulations is reduced
  • Ex post policy evaluation takes the objectives as given and assesses whether the effects of the policies contribute to reaching the objectives.
  • Ex post evaluation investigates whether the intended effects were achieved or whether future policies need to be adjusted.
  • Ex post evaluation also considers unintended consequences, which includes the cost of regulation to the financial sector.
  • Ex post evaluation investigates whether the intended effects were achieved, independent of the intensity of regulations.

5 Results of the evaluation of the TBTF reforms

Have the policy changes that took place after the global financial crisis worked? Are banks now safer? Has the problem of TBTF been solved? In 2019, the Financial Stability Board started a large-scale ex post evaluation of its TBTF reforms to answer these questions.

The TBTF evaluation focused on the channels through which reforms are expected to operate: resolution reforms that provide public authorities with more options for achieving a resolution for banks, changes in the behaviour of banks, and changes in the pricing of bank risk in financial markets. Moreover, for the reforms to succeed, these mechanisms must be sufficiently strong to enhance financial stability.

It is important to note that successful reforms are not only measured against the frequency of financial crises or of actual bank failures. Rather, the purpose of the reforms is also to make sure that the impact of a crisis, if it happens, has been reduced. The greater the progress in implementing the reforms, the stronger these effects should be. The effects of resolution regimes work through implicit funding subsidies and the risk-taking decisions of banks. We can observe these effects even without observing an actual bank failing.

Let’s take a look at some of the findings of the FSB ex post evaluation.

Choices of banks

capitalization
The expansion of a bank’s capital base. Capital is the money that a bank has obtained from its shareholders and any profit that it has made and not paid out. Consequently, if a bank wants to expand its capital base, it can do so by issuing more shares or retaining profits, rather than paying them out as dividends to shareholders. Source: ECB.

The evaluation of the Financial Stability Board looked at several indicators that can provide information on bank behaviour. Figure 4 shows changes in the capitalization of systemically important banks, distinguishing three types of banks: globally systemically important banks (G-SIBs), domestically systemically important banks (D-SIBs), and a ‘control group’ of all other, smaller, non-systemic banks. Figure 4 shows banks’ capital relative to total risk-weighted assets and to total assets.

Figure 4 Evolution of risk-weighted and unweighted capital ratios for banks (%).
Note: The chart illustrates how risk-weighted (RWAs = risk-weighted assets) and unweighted capital ratios for D-SIBs, G-SIBs, and banks that are not systemically important have evolved.

Figure 4 shows that, for all banking groups, capital ratios have increased since the global financial crisis, which means that banks are now more resilient against shocks. This was demonstrated at the outset of the COVID-19 pandemic in 2020 when banks had buffers against losses.

The COVID-19 pandemic is different from the global financial crisis as the shock did not originate in the financial system. Governments and central banks intervened massively to support the economy. The FSB and the ESRB provide overviews of what happened.

The capital ratios of SIBs increased by more than those of other banks. So, in terms of the changes, their capitalization has increased faster. In terms of the levels, however, larger banks still have higher leverage, in other words, lower ratios of equity to assets. This may reflect differences in business models if, for instance, large banks are more diversified and therefore less risky.

And not only are systemically important banks better capitalized than before the reforms, they have also issued debt that can potentially be bailed in. In fact, most G-SIBs already (as of end June 2020) meet their 2022 final loss absorbing requirements described in Section 4.

profitability
A measure of the ratio of profit to capital invested. Profitability is sometimes used as a synonym for return on equity, which is calculated as the ratio of net profit to equity over a specified period, expressed as a percentage. Source: Bundesbank glossary.

The increase in bank capital has implications for bank profitability: profitability as measured through return on equity has tended to fall for systemically important banks relative to other banks. This may reflect higher capital, lower risk, and higher funding costs if implicit funding subsidies have declined. This might look like a negative side effect of the reforms: owners of banks or managers with compensation tied to the return on equity have lower incomes. But, from the point of view of society, the interpretation may be different: higher capital, lower risks, and lower implicit funding subsidies actually make the banks safer, lower the costs of potential bailouts for tax payers, and reduce distortions to competition. Hence, from a social perspective, lower bank profitability can very well be consistent with successful policies to address the TBTF problem.

bank lending
A loan where the lender (the bank) provides a borrower with a sum of money for a limited period of time. The borrower is obliged to pay interest to the lender. There are numerous types of loans, which are characterized by different maturities (date the final repayment is due), type and scope of collateral, or use (e.g. real estate credit, overdraft facility, instalment loan). Source: Bundesbank glossary.

Changes in bank lending are another example of why a distinction between the perspective of individual banks and the perspective of the overall economy is important. Banks that face higher capital requirements have different options to achieve compliance. They can increase their capital ratios by raising more capital or by retaining profits. But they can also reduce lending and shift their balance sheets towards activities with lower regulatory risk weights. This route is particularly attractive for banks that have low capital ratios in the first place.

However, when you step back a little and look at the overall provision of credit to the economy, a quite different picture emerges: overall credit has not declined, it has increased!

The increase in credit is one key finding of the FSB’s TBTF evaluation. The Bank for International Settlements (BIS) publishes detailed information on the evolution of global credit.

When you look only at the market shares of systemically important banks in terms of total bank assets or lending, you see a declining trend (Figure 5). However, smaller banks have taken over some of the business of larger banks, as have non-bank financial intermediaries such as asset managers and hedge funds. So customers’ access to credit has not suffered.

The important question for regulators is whether risks have shifted to other areas of the financial system. There is, in fact, a lot of work going on at the FSB to look at exactly this question and monitor risks in non-bank financial intermediation—including the risk that non-bank financial institutions such as asset managers become TBTF and need to be regulated accordingly.

Another term used to describe non-bank financial institutions is ‘shadow banks’. Banks engage in maturity transformation, and they are highly leveraged: they have far less equity in relation to their assets than other firms. (Read Section 10.8 of The Economy to learn more about maturity transformation.) These two characteristics mean that they are inherently fragile. Most non-bank financial institutions—pension funds for example—do not share these characteristics. But some do, and these ‘shadow banks’ have the greatest potential to give rise to systemic risk. The FSB, therefore, monitors risks in these parts of the system. It described in March 2020 the role of non-bank financial intermediaries in the aftermath of the pandemic shock in financial markets.

But the bottom line is that one needs to look at changes in banking markets and the effects of regulations through the lens of social costs and benefits, not private costs and benefits. Also, one needs to look at the overall economy rather than specific market segments, and to consider how the system evolves over time.

Figure 5 Market shares of the top three systemically important banks in gross loans.

Systemic risk

The indicators of the TBTF problem discussed so far focus on the balance sheets of banks, their lending behaviour, and their funding. They do not really tell us much about the risk that banks impose on the financial system. Recall that banks can create negative external effects for the financial system that individual banks do not internalize: if banks experience a negative shock to capital, they may fail to anticipate that other banks have capital shortages, too.

Measures typically used in the academic literature to measure systemic risk are related to the description of the TBTF problem introduced in Figure 1 (Section 2). That figure shows that banks can be systemically important if they are highly linked to the financial system—directly or indirectly—and if they are insufficiently capitalized. And their impact on the financial system depends on the fragility of other banks that may run into difficulties at the same time. Systemic risk can therefore be measured through the gap between potential losses in the banking sector and the capital that is available to cover such losses, and the contribution of an individual bank to this gap. The information needed, therefore, is: how big are potential losses in the financial system? How much capital is there to cover those losses? And what is the contribution of an individual bank?

Answering these questions requires the definition of a relevant market. That relevant market can be the domestic financial system, a regional (for example, the European) financial system, or the global financial system. If markets are not very integrated across borders, it may suffice to look at the domestic economy. But if the degree of financial integration is high—as in Europe—a broader definition of markets is needed.

Using such measures, the FSB’s TBTF evaluation concludes that, overall, measures of systemic risk have remained relatively stable over time, while the impact of G-SIBs has declined somewhat. Because of its mandate to monitor financial stability risks at the global level, the FSB evaluation report focused on changes in cross-border lending. Cross-border connectedness can be measured through the claims that banks have on borrowers in other countries or regions. Such measures of connectedness indeed reached peak values at the onset of the financial crisis and, after a sharp drop in 2008, have returned to or surpassed their pre-crisis levels.

The V-Lab provides data and further information on systemic risk around the world. The Bank for International Settlements provides statistics on cross-border connectedness.

Implicit funding subsidies

There have been changes in the behaviour of banks, and new resolution regimes have been implemented. Has this changed implicit funding subsidies? Answering this question is not easy because implicit subsidies are not observable. Hence, we need indirect measures to find out whether the subsidies have actually been withdrawn by the reforms, as intended. An intuitive way of assessing changes in funding costs is to compare the funding costs of larger and smaller banks. But this simple comparison does not do the trick; there may be many other reasons why lending to larger banks is less risky than lending to smaller banks. Larger banks may have better management or be more diversified than smaller banks, and, if so, this could also make them less risky. So to observe the effects of systemic importance on funding costs, it is necessary to isolate all other factors that could contribute to lower risk.

credit rating
A classification of debtors or securities in terms of their creditworthiness or credit quality. These classifications are generally carried out by credit rating agencies. The highest creditworthiness rankings are denoted as AAA or Aaa by the most well-known agencies, while less creditworthy ratings are denoted with different combinations of letters and numbers. Credit ratings agencies consider the credit quality of debtors or securities rated BBB- or better as ‘investment grade’. Those with a lower rating are classified as speculative; such securities are also referred to as high-yield bonds. Source: Bundesbank glossary.
credit ratings agency
A firm which collects information to calculate the credit-worthiness of individuals or companies, and sells the resulting rating for a fee to interested parties.

One approach to estimate implicit funding subsidies is to exploit different types of credit ratings. Some credit rating agencies issue a ‘support rating’, in which they assess the likelihood that the government will support a bank if it fails. They also issue a ‘standalone rating’, which assesses the strength of the banks assuming no government support.

Find out more Implicit guarantees and funding cost advantages of systemically important banks

Because implicit guarantees are quite important, let’s take a closer look at how they can be estimated. Let’s start from the simplified balance sheet of a typical bank. The right-hand side consists of equity and liabilities. Liabilities, in turn, comprise deposits and bonds (see Section 11.5 of the Economy). Funding cost advantages can be estimated by looking at the interest rates that these bonds yield. The funding cost advantage (FCA) of a financial institution i in period t can be measured as the difference between its actual funding cost and its hypothetical funding costs if it were not benefiting from an implicit guarantee:

Funding cost advantages are a proxy for the implicit government subsidy accruing to systemically important banks, and are thus the expected bailout that bondholders expect to receive. The funding cost advantage can be decomposed into the expected value of the implicit government guarantee, given by the probability of default, and the expected recapitalization by the government (that is, the money that governments provide to cover losses). The first component is the joint probability that the bank is both in distress and being bailed out. The second component measures the losses due to bank distress with and without a bailout (the ‘loss given default’ or LGD):

The probability of failure depends on bank-level choices related to bank risk. The probability of being bailed out, given that a distress event has occurred, , is influenced by a number of factors. Regulations affect how easy it is to deal with a failing bank. The fiscal situation also has implications for the ability of governments to bail out financial institutions and provide support to the financial system in times of crisis. Section 22.13 of The Economy (Section 12.9 of Economy, Society, and Public Policy) discusses how fiscal capacity constrains the types of policies that authorities can implement.

Figure 6 illustrates the evolution of the funding cost advantage of SIBs based on the factor pricing approach. This approach compares the return on a portfolio of SIB stocks with the return on a portfolio of stocks of other banks, taking into account other risk factors. This measurement provides an estimate of the equity market’s perception of TBTF risk. What is important in this figure are the patterns over time. Prior to the global financial crisis, funding cost advantages of large banks were positive, but relatively small. During the financial crisis, funding cost advantages increased, due to a rise in both the perceived probability of default and the perceived probability of bailout, given default. Following the crisis, funding cost advantages remained at a relatively high level. But after TBTF reforms were implemented, the funding cost advantages fell.

Figure 6 Funding cost advantage of systemically important banks.
Note: This figure shows the funding cost advantage of SIBs based on factor pricing approach. This approach compares the equity returns of a portfolio of SIBs vs a portfolio of non-SIBs, accounting for macroeconomic and bank-level factors. This measurement provides an estimate of the equity market’s perception of TBTF risk.

Policy evaluation: challenges and information sources

Trends in banks’ activities and funding costs can arise for very different reasons, not necessarily because of the reforms. Good causal evaluations need to take into account other factors: post-crisis reforms include not only TBTF reforms, but also other financial sector reforms; monetary policy used unconventional instruments such as asset-purchase programmes; and bank-specific and country-specific factors matter for observed outcomes. There is, therefore, a great deal of variation in the data. This raises the question of what drives the differences: is it the regulations? Is it other, unrelated factors? Or is it just randomness in the data?

As there is no ‘gold standard’ that addresses all empirical problems, it is useful to compare different studies to see whether a consistent picture emerges. Many empirical studies have, for example, looked at the effects of Basel III. The repository Financial Regulation Assessment: Meta Exercise (FRAME) contains standardized estimates of the impact of policies on economic variables such as the provision of credit. It was set up by the Bank for International Settlements (BIS). The initial version of FRAME, launched in 2019, focuses on the effects of capital and liquidity standards implemented under the Basel III reforms. Empirical papers estimating the implicit funding subsidies of banks have been added to FRAME as well.

In addition, there are many useful sources for empirical work on international banking. The International Banking Research Network uses datasets for different countries and a common empirical approach to assess the effects of regulations, shocks, and other policy measures on globally active banks. The International Banking Library provides an overview of studies on the activities of international banks as well as links to data sets on banks and banking regulations.

The effect on its funding costs of a bank being systemically important (the ‘SIB effect’) is illustrated in Figure 7. In this figure, the distribution of impact estimates is based on 106 estimates from 19 studies corresponding to sample periods between 2007 and 2018. Negative estimates represent funding cost advantages for systemically important banks over other banks (the control group). These estimates correspond to unexplained funding cost advantages, which cannot be attributed to any macroeconomic, financial or business-related factors, and are therefore interpreted as implicit guarantees.

Figure 7 SIB effect and bank funding cost.
Note: Distribution of effect of a bank being systemically important on its funding cost. Negative estimates represent funding cost advantages for SIBs. (Results are expressed in percentage points). Based on 106 standardised estimates from 19 studies.The legend indicates which method was used to obtain the estimate of bank funding costs.

Buch, Dominguez-Cardoza, and Völpel 2021, FRAME, TBTF section, BIS.

The size of the estimated funding cost advantage for SIBs ranges from around zero up to 3.5 percentage points. In terms of economic significance, one can compare the magnitude of the funding cost advantages with, for example, the Aaa corporate bond yield, to determine its economic significance. An Aaa bond is very highly rated and is thus considered to be of low risk. In the same period, 2007–2018, Aaa corporate bond yields ranged between 3.4 and 6.3 percentage points. If investors did not expect large banks to be bailed out, their funding cost could increase up to 3.5 percentage points, which would imply an increase of more than 100% (i.e. 3.5/3.4 = 103%) for a 3.4% bond yield. Estimated funding cost advantages can therefore be highly economically significant.

The evidence collected in FRAME provides a number of insights:

Question 7 Choose the correct answer(s)

How can systemic risk be measured?

  • through the probability that an individual financial institution faces losses
  • through the probability that an individual financial institution has a capital shortfall when the entire financial system is under stress
  • through the probability that a health pandemic affects the economy
  • through the costs of financial crisis for the government
  • Losses of an individual institution do not necessarily impact the rest of the system.
  • This indicator has been proposed by researchers to measure the contribution of a financial institution to systemic risk.
  • Although a pandemic can have a considerable effect on the financial system, it is an external effect that is not intrinsic to the financial system.
  • Systemic risk describes the intrinsic vulnerability to a crisis, while the costs of a financial crisis are associated with a particular failure.

Question 8 Choose the correct answer(s)

Which results of ex post policy evaluations would show that TBTF reforms have had their intended consequences?

  • Funding cost advantage of larger banks has decreased relative to smaller banks, ceteris paribus.
  • Interest rates have dropped close to zero, suggesting less risk in the financial sector.
  • Event studies show that funding costs have increased for systemically important banks.
  • Systemically important banks have moved to less risky activities.
  • Funding cost advantages may have causes other than implicit guarantees (for example, more risk diversification of large institutions).
  • Interest rates are the result of many macroeconomic conditions and do not serve as an appropriate evaluation for TBTF reforms.
  • This serves as an appropriate indicator that risk has been internalized into the funding costs.
  • It is the purpose of the reforms to reduce systemic risk.

Exercise 2 Evolution of SIBs’ funding cost advantages

Use the FRAME repository to answer the questions below.

  1. The table for impact estimates of the FRAME repository allows you to visualize the results of many studies. If you click on the TBTF proxy menu, you can query the results for ‘SIB effect’ and ‘SIB x Reform effect’, among others. Look at the graphs and their descriptions, and explain what the terms ‘SIB effect’ and ‘SIB x Reform effect’ refer to. You can find an even more detailed description in the repository report, which is available on the overview page.
  2. Under the Breakdown options menu, you find different ways of disaggregating the estimates. Use the Regimes option and compare the ‘SIB effect’ in the pre-reform and post-reform periods. Do you notice a difference? Describe how the estimates differ between the periods.
  3. Now break down the estimates by sample year. What was the average funding cost advantage for SIBs in 2007? Did the funding cost advantages for SIBs increase or decrease in 2008 and 2009? Recall what you have learned about implicit guarantee expectations. Discuss how this might have had an impact on the funding cost advantage for SIBs after government bailouts in the years 2008–2009. You might want to filter out some of the years by clicking on the legend of the interactive graph.

6 Conclusion

The global financial crisis had massive and long-lasting implications for the stability of the financial system, the real economy, and society. In contrast with the COVID-19 pandemic, which was a global health shock that deeply affected the real economy and threatened to affect the financial system, the global financial crisis originated in the financial sector and spilled over into the real economy. Large and systemically important banks were at the centre of the crisis. Before the crisis, regulation of systemically important banks was inadequate: it did not set proper incentives to mitigate risks, and it did not provide a way to deal with risks that had materialized.

Addressing these shortcomings of the regulatory framework has been the objective of post-crisis financial sector reforms. Financial regulations have been overhauled in order to increase the resilience of individual financial institutions, to reduce moral hazard, and to prevent the build-up of systemic risk in the financial system.

This CORE Insight has focused on TBTF policies. It has:

Overall, the case is not closed. Indicators of bank behaviour and systemic risk have moved in the intended direction, and public authorities now have the tools to deal with failing banks. But we cannot really know whether a bank is TBTF until it fails and we see how the authorities deal with it. Solving the TBTF problem is an ongoing project. Regulations addressing systemic risk externalities have to be implemented and enforced. Other financial intermediaries have entered the scene, and non-bank financial intermediation has gained in importance. Even if the TBTF problem has been mitigated in the banking system, it could arise in the non-bank financial sector. Addressing TBTF risks and monitoring risks to financial stability therefore remain a priority.

7 Acknowledgements

The authors would like to thank Florian Bichlmeier, Samuel Bowles, Wendy Carlin, Andre Ebner, Cloda Jenkins, Eileen Tipoe, Edgar Vogel, Benjamin Weigert, and Matthias Weiß for their most helpful comments and suggestions on an earlier version. The views expressed in this paper are those of the authors and do not represent the views of the Bundesbank, the Eurosystem, or the Financial Stability Board (FSB). All errors and inaccuracies are our own.

8 References

  1. Mathias Dewatripont and Jean Tirole. 1994. The Prudential Regulation of Banks. Cambridge, MA: MIT Press. 

  2. FSB. 2010. ‘Reducing the Moral Hazard Posed by Systemically Important Financial Institutions’. Basel: FSB. 

  3. FSB. 2011. ‘Policy Measures to Address Systemically Important Financial Institutions’. Basel: FSB. 

  4. BCBS. 2018. ‘Global systemically important banks: Assessment methodology and the additional loss absorbency requirement’. Updated 18 December 2020.