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Too Big Too Fail Essay

1267 words - 6 pages

 The cost to society from the failure of a large, complex bank (what is known as Too Big To Fail) is considerably higher than the cost to society of the failure of a non-systemic bank. This is because of their complex interconnectedness with the other institutions in the market. TBTF banks engage into activities and services with a network of other institutions in such a way that if a TBTF bank becomes insolvent, all those in the network will be at risk. For example, following the bankruptcy of Lehman Brothers, contagion spread by many channels, including prime brokerage, OTC derivatives positions, money market mutual funds, tri-party repo and wholesale funding markets. The cost to society ...view middle of the document...

What is interesting in this context is that the US not even a decade before the recent crisis repealed the Glass Steagall act, which prohibited commercial banks to engage in investment banking activities. Some argue that the Steagall act has strengthened commercial banks and made the financial system more reliable since banks were no longer able to jeopardise their customers’ money on risky investment activities. However, others argue that diversified banks that can engage in all kinds of financial services are beneficial for the stability of the financial system.

It was argued that the separation of commercial and investment banking weakened US banks relative to foreign rivals who were not constrained by those limitations. (Calomiris, 2000)

Separating commercial from investment banking can solve the phenomenon of TBTF banks.

One of the main solutions to as to why commercial and investment banking should be separated is the concern that conflicts of interest will arise when the same entity that grants credit to customers uses credit to invest. For example, if a bank has outstanding loans to a corporation and prior to public knowledge finds out that the firm is in financial trouble, a bank may underwrite bonds on behalf of this firm and require the corporation to use proceeds to repay the bank loan. However, evidence in the literature on the existence of conflicts of interest is mixed. For example, studies based upon data from the Great Depression era, such as those by Kroszner and Rajan (1994), Puri (1996) and Benston (1990) together with more recent studies from Heb b and Fraser (2003), which are based upon findings from Canada and the UK rejects the existence of conflicts of interest. These studies mainly base their evidence upon the fact that bonds underwritten by commercial banks default less often than bonds underwritten by investment banks. This implies a separation of commercial and investment banking might not be the best solution. However, Bessler and Stanzel (2009) and Johnson and Marietta-Westberg (2009) argue that a conflict of interest is more sever and more likely to exist in a bank that has an underwriting division and asset management division. The main argument here is that asset management divisions appeared to give worse investment advice to the public, compared to stand-alone asset managers. Thus it is important that regulators are aware of these issues and that they actively aim to limit the possibility for universal banks to mislead the public through market making and poor investment advice. One way of doing this would be to separate commercial and investment banking.

This effectively shifts increased default risk from the bank to the securities market and its investors (Hebb and Fraser, 2002). Thus, a separation of commercial and investment banking could stop such activities in which banks actively try to...

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