"[…], we must reduce the moral hazard posed by institutions that are too large, or too complex, or too interconnected to fail. The large-scale support we provided in this crisis to stave off systemic collapse has materially worsened moral hazard risks. Why should our financial firms now believe that authorities will not stand behind them if conditions were to turn again to the worse? Moreover, many of our banks have become larger, not smaller as a result of crisis-related mergers. Moral hazard risks pose a large prospective burden for taxpayers and are a serious threat to the maintenance of a market-based system." (Mario Draghi, 9.12.2009)
We very much agree with Mr Draghi – large banks are not only dangerous, they distort competition.
Here is how we would describe the ‘too-big-to-fail’ problem:
Liberalisation has led banking activities to expand beyond their traditional core functions. We need banks to take deposits, create and allocate credit and maintain the payments system. But banks have grown out of all proportion to the economy, mainly by increasing the amount of financial trading they do with other financial firms. They are now too-big or too-important-to-fail, forcing taxpayers to rescue them in case of failure.
The public therefore provides a safety net, which lowers banks’ funding costs and encourages them to take risks they would not otherwise take. Their funding costs are artificially low and they grow bigger as a result, which increases the value of the safety net even more. It’s a vicious circle that hurts the market in good times and in bad: in good times it subsidises financial trading and distorts competition between too-big-to-fail and smaller banks, in bad times it causes financial crises and recessions.