Who Benefits and Who Loses from TBTF Banks: The Economics of Too-Big-to-Fail

(Picture taken from Sucker Punch Cinema)

In response to German finance minister Peer Steinbrück’s plans to separate commercial banking from other businesses, Mr Achleitner recently argued against splitting up universal banks like Deutsche Bank, on whose board he sits, by claiming that all experts know that broadly diversified companies like universal banks pose less risk than more focussed firms. Some of Mr Achleitner’s arguments are questionable and warrant clarification.


Mr Achleitner tries to convey the impression that risk is bad. Fact is that risk is nothing bad per se and hence something to be avoided as risk is compensated for by reward. This means that with increasing riskiness, the expected return rises accordingly. Following Achleitner’s logic, neither bio tech companies nor bungee jumping should exist. As bio tech companies are clearly more risky than, for example, Coca Cola in terms of returns, no investor would chose to invest in bio tech having the alternative of Coca Cola if Achleitner’s risk paradigm held. But it doesn’t, and so investors do. Similarly, nobody would consider bungee jumping following Achleitner’s logic. But again, people do. In analogy to higher expected returns on risky companies, people derive pleasure from activities like bungee jumping that compensate them for the risk they are taking; otherwise there wouldn’t be any bungee jumpers.
Analogously to the two examples above, banks like Deutsche Bank give loans to clients of varying risk characteristics. They do not, however, engage in such activities because of their philanthropic attitude but because of the simple fact that it’s profitable as higher risk clients pay higher interest rates in order to compensate for the risk.


In fact, the contrary is true. A wide array of research finds that diversified companies are riskier than non-diversified companies.
Diversified firms destroy wealth for shareholders: Studies document that conglomerates trade at substantial discounts to more specialised competitors, implying that they are riskier than their individual parts would be. Berger & Ofek (1995), for example, estimate the value loss at between 13% and 15%. Subsequent studies confirm that diversified firms are penalised by investors and hence are not value-maximising (Lamont & Polk 2001; Ahm & Denis 2004). Usually, agency problems are put forth in order to explain why conglomerates are worth less than the sum of their individual parts. (I’ll cover this topic in a separate post.)
Surprisingly, examining the banking sector, Elsas, Hackethal & Holzhäuser (2010) do not find any conglomerate discounts around the turn of the millennium. Similarly, Baele, De Jonghe & Vennet (2007) find that a higher share of non-interest income of overall income (i.e. diversification) actually increases banks’ value.
This discrepancy between financial and non-financial firms is displayed by historical developments. During the 1950s and 1960s, firms tended to diversify their businesses widely, leading to many prominent conglomerates but ultimately to inefficient firms. As a result, the 1980s saw a reversal of this trend back towards more focussed firms again. The development in the banking sector is quite different: For the past two decades, while non-financial firms disinvested and specialised, banks have been increasing business diversification. Elsas, Hackethal & Holzhäuser (2010) calculate that the level of diversification of large banks rose by more than one third from 1996 to 2003 as commercial banks expanded fee-based activities, banks with already high fee income moved into trading business and other banks started to offer insurance services.

Yet, regardless of extensive diversification in the banking sector, banks do not seem to suffer from conglomerate discounts but rather show increasing profitability with decreasing business focus.
This increased profitability from diversification in the banking sector does not, however, mean that it is less risky. On the contrary, because diversification in the financial sector increases risk do investors demand lower returns and profits increase. This apparent counterintuitive relationship is due to the fact that financial diversification comes at the cost of increased market risk (Baele, De Jonghe & Vennet 2007) and systemic risk. While market risk in finance denotes the risk of any particular company that arises from the vulnerability to the overall market, systemic risk is the danger of a collapse of the entire financial system as a result of any single financial institution defaulting, similar to a domino effect. Especially systemic risk is important as it is of great relevance to the stability of the financial sector and as a corollary of great interest to regulators. And it is systemic risk in particular that large banks impose on the financial system.

In short, a bank’s size is directly related to profitability, the risk it is exposed to from the market as well as to the risk it poses to the financial sector and ultimately to the economy. This relationship is, of course, exceptionally valuable to banks. If banks grow in size, not only will their profits rise (disproportionally) but also will the risk of bankruptcy decrease because large banks’ failure would jeopardise the economic system. As a result, large banks know that they will be bailed out by the government if – when – tail risk materialises.

From this increased danger that large banks constitute, which makes it impossible to let them fail for governments and central banks, arises a strong incentive to grow. In a study from 2009, Brewer & Jagtiani (2009) provide conclusive evidence that US banks have been willing to pay significant premiums for mergers that would make them too-big-to-fail. These premiums are, of course, only paid because future benefits in the form of indirect government subsidies and implicit bailout guarantees in times of distress outweigh these costs. A recent study conducted by Gandhi & Lustig (2012) finds that the US governments subsidises large banks to take on tail risk by $4.71bn per year per bank, on average. Not only is the cost of equity capital distorted by implicit government insurance but also do these practices interfere with competition in other respects. Since TBTF banks are unlikely to go out of business, they enjoy significantly more trust as their survival is implicitly guaranteed by the government. As a result, big banks grow even bigger because they are able to attract more deposits (at lower cost) than smaller competitors because the former are (rightly) perceived to be safer.


This point is actually so wrong that I don’t know where to start and any attempt to list the experts that disagree with Mr Achleitner necessarily will be incomplete. But let’s give it a try by subsuming into categories, listing only the most important representatives:

  • Central banks:

Proponents of splitting up too-big-to-fail banks include Bank of England’s Haldane, recently arguing that existing regulation “provide[s] a subsidy to complexity” which makes them even bigger. Haldane hence expressed his opinion that big banks need to get smaller in order to regulate them efficiently again.
Harvey Rosenbaum of the Dallas FED recently called TBTF policies “a perversion of capitalism” in a 22-page essay within the 2011 Annual Report of the Federal Reserve Bank of Dallas. In the same report, Dallas Fed president Richard Fisher describes TBTF institutions as a hindrance to capitalism.

Harvey Rosenblum, Federal Reserve Bank of Dallas

In 2004, Ron Feldman & Gary Stern of the Federal Reserve Bank of Minneapolis authored a book called “Too Big to Fail – The Hazards of Bank Bailouts” which analyses the problems of TBTF most thoroughly.
Former chief executive of the Federal Reserve Bank of Kansas City and current director of the Federal Deposit Insurance Corporation, Thomas Heonig, stressed that TBTF threatens small banks.
Moreover, former chairman of the Federal Reserve Paul Volcker has been advocating splitting up TBTF banks for several years.
Finally, and probably most surprisingly, even the omnipotent former FED chairman Alan Greenspan, under whose aegis the bulk of TBTF building had happened unimpededly, called for breaking up big banks.

  • Bank CEOs:

Most importantly, Sandy Weill, who almost single-handedly transformed Citigroup into what it is today – one of the most important TBTF institutions – by merging Citigroup and Travelers (an insurer with investment banking divisions like Smith Barney and Salomon Brothers, which had been acquired by Travelers the year before) in 1998 when Glass-Steagall was still in place now considers TBTF banks a serious problem.

  • Experts:

Suffice it to say that I am not aware of any expert who believes TBTF institutions are not a problem – or, as Mr Achleiter argues – are actually beneficial to the economy. While some in academia like, for example, Frederic Mishkin, argue that TBTF may be not as serious a problem as sometimes believed (although this perception was expressed in 2006), and Paul Krugman argues for much tougher regulation as opposed to shrinking big banks on the grounds of economies of scale, there is widespread consensus amongst experts that TBTF constitutes a problem. One of the most prominent economists of our time expressed the TBTF problem aptly as follows:

Joseph Stiglitz, Nobel Prize Laureate

Bottom line, the risk of failure is an essential feature of any market economy. Only if certain firms – large banks – cannot be allowed to fail, risk is dangerous because it threatens the market system. For over two decades, too-big-to-fail banks have been able to extract TBTF rents at the cost of taxpayers and are now, of course, unwilling to break themselves up and lose one of their most important profit centres – taxpayers’ subsidies. It is before this background that Mr Achleitners remarks ought to be understood. Whenever firms or sectors manage to get themselves a free lunch, they are naturally unwilling to leave the buffet. Fact is, however, that TBTF banks are not safer for the economy, they are just safer for shareholders because taxpayer take on part of the risk –  without, of course, being compensated in good times.



  1. Thanks in support of sharing such a pleasant opinion, paragraph is nice, thats why i have read it completely

    1. Thanks, Steven, much appreciated.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: