Why ‘too big to fail’ insurance is the worst of all worlds


“Too big to fail” insurance is likely to leave the non-financial economy with the worst of all possible worlds – less public control of risk and greater potential calls on taxpayers.

The main headline in Saturday’s Financial Times was “Bankers in favour of paying global tax”. A more newsworthy headline than “man bites dog” and only a little behind “Pope not a Catholic”. The bankers quoted were Josef Ackerman of Deutsche Bank and Bob Diamond of Barclays; so you might suspect that there was both more, and less, to their enthusiasm than met the eye. You would be right.

Both gentlemen expressed support for a levy on banks to fund an international rescue fund for institutions deemed “too big to fail”. Implemented globally, such a plan would not change the competitive position of individual banks, although its universality raises the likelihood that the tax would be passed on to savers and borrowers. The fund would secure stability of the financial system while avoiding future burdens on taxpayers.

Perhaps. More likely, by institutionalising the concept of “too big to fail”, the scheme would aggravate the underlying problem of moral hazard. It would also transform state funding of the banking system from an exceptional response to a dire emergency into an expectation, even an entitlement.

The troubled asset relief programme made $750bn of US Treasury funds available to American companies. The National Audit Office has estimated the total value of subsidiaries, injections and guarantees in the UK at close to £1,000bn ($1,590bn, €1,150bn). Germany, France and the European Central Bank also made large financial commitments. A fund adequate to secure stability of the global financial system without recourse to taxpayers would need access to several trillion dollars.

No one imagines this would really happen. The money to underwrite a financial crisis on the scale of 2007-08 would come, in the future as in the past, from the only credible underwriter for sums of that magnitude – taxpayers of developed economies. The hope might be that loans and guarantees would in the end cost much less than the headline amounts and part of the costs would be recovered from the industry. But there is no sense in which ordinary citizens would be off the hook for the costs of financial failures.

Still, the idea that banks should pay a risk-related levy to reflect the costs their activities may impose has considerable appeal. What would be a reasonable premium for “too big to fail” insurance? There is now an active market in credit insurance – and a credit default swap rate for an advanced country averages around 80 basis points. The rate for a large bank without government support could hardly be less. Even that rate, applied to the total liabilities of global banking, would probably eliminate all banking profits.

There are two ways of interpreting that calculation. One is that bank profits do not compensate for the economic risks created for the global economy. The other is that the market greatly overestimates credit risks. There may be some truth in both explanations, but banks and their regulators would prefer the second. It is a safe bet that risk-related premiums for banks set by a regulator would be much lower overall, and would vary less by category of risk, than market rates. Such features characterise all state- provided or regulated insurance, from motor insurance to healthcare, and including deposit insurance.

There is, however, a critical difference between credit insurance and normal insurance. If I sell health insurance for less than a fair premium, you do not have the option of buying more than you need and selling it on. But in credit markets, you can. Banks have exploited that opportunity profitably, especially in the last year. And would do so on a larger scale if such support were extended and formalised.

“Too big to fail” insurance is likely to leave the non-financial economy with the worst of all possible worlds – less public control of risk and greater potential calls on taxpayers. It would entrench the position of incumbent institutions that are already too large and too diverse. The best way to deal with the “too big to fail” problem is to abolish it, not to accommodate it.

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