Why Do Banks “Need” to be “Too Big to Fail”?

I was at a conference last week and Federal Reserve Governor Dan Tarullo asked a question that I’ve been wanting to know the answer to as well: Why do banks “need” to be so big that they are “too big to fail”?  More precisely, it is asserted (but, in my opinion has never been demonstrated) that banks above a certain size are so large and intertwined that we “have” to bail them out.  As a result of this bailout imperative and the supposed systemic risk, “too big to fail” banks create an externality on the economy by the implicit government guarantee.

In light of this externality, the relevant question is, “Why do banks need to be so big that they are considered ‘too big to fail’?”  In other words, what economic value would be lost if banks were at a size just below the threshold of what is considered “too big to fail”?  What efficiencies or product offerings would be lost if banks were big, but not “too big”?

Tarullo asked this question more concretely in a recent speech:

Well before the financial crisis and my arrival at the Federal Reserve, I had found that the relative dearth of empirical work on the nature of economies of scale and scope in large financial firms hindered the development and execution of optimal regulatory and supervisory policies. Some regulatory features added by the Dodd-Frank Act only increase the importance of more such work to fill out our understanding of the social utility of the largest, most complex financial firms. Ultimately, we want to understand what these scale or scope economies imply for the degree to which large size or functional reach across many types of financial activities is essential for the efficient allocation of capital and liquidity and for the international competitiveness of domestic firms….

But I am getting ahead of things here. Returning to my starting point, I reiterate that the importance of this research agenda lies precisely in determining how significant these trade-offs might be. The events of the past few years make brutally clear the potential for societal damage associated with systemic risk. Considerable work has already been done by academics and policymakers to develop systemic risk metrics, and thus to lay the groundwork for sound macroprudential regulatory measures. As we and our counterparts in other countries move forward with the implementation of these measures, a complementary stream of work on scale and scope would substantially enhance these efforts.

I recognize that studying scale and scope economies in large financial conglomerates presents some practical challenges. The small number of very large and diversified financial firms, the difficulties delineating specific activities of interest, and the problems in measuring economic costs all complicate the undertaking. So too, disentangling real economies from the funding advantages associated with moral hazard, or the supra-competitive profits associated with a concentrated industry structure, may not be easy. Perhaps, then, in the short term, the research community and regulators may benefit from case studies that inform the direction of future research.

Given the absence of any explanation to date as to why banks need to be so big, one is left for now with the only apparent explanation still left: precisely because being so big gives them an implicit government guarantee, which allows them to access capital markets more cheaply and gain a competitive advantage that their rivals lack.  If anyone has any empirical evidence that justifies the size of banks that are too big to fail, I’d like to see it.

Kudos to Governor Tarullo for asking the right question.