Lesche too big to fail in banking impact of g SIB designation and regulation on relative equity valuations (2021)

General Context and Current Developments

Banks play a vital role in the economy by directing surplus funds from individuals and institutions lacking investment opportunities to those who can utilize them effectively This function is essential for fostering economic growth, and as a result, banks receive special privileges However, responsible management is crucial to fulfilling their public duty, as they must navigate inherent risks such as credit risk from debtor defaults and liquidity risk from potential bank runs Poor management of these risks can exacerbate economic crises, highlighting the importance of sound banking practices.

Historically, responsibility and liability were closely linked, but this connection has weakened for banks over the centuries Following various banking crises, stakeholders have leveraged their influence to transfer liability and risk onto taxpayers while retaining profits Key outcomes of these negotiations include special bankruptcy proceedings, public deposit insurance, and the establishment of a lender of last resort Today, to enhance financial stability, depositors are protected from losses, other creditors seldom experience write-offs, and owners’ liability is often confined to their invested capital.

While it can be argued that high leverage is common across various firms, banks uniquely attain this through insured creditors and inexpensive funding sources This phenomenon may challenge the Modigliani–Miller theorem, which posits that the overall cost of capital remains constant irrespective of leverage In contrast, non-banking institutions are unable to achieve high leverage in a cost-effective manner.

Asymmetric shareholder payoff schedules have driven increased volatility in banks' assets, while the ability to claim tax deductions on debt finance costs has encouraged banks to heavily leverage their capital structure with debt This precarious framework has supported significant economic growth over the decades, primarily benefiting short-term investors and bank management, often at the expense of the public.

The support for no-liability bank stakeholders has allowed banks to evolve into mega-banks that are deemed irreplaceable by governments concerned about the economy While guaranteeing liabilities and protecting equity benefits bank stakeholders, it places a heavy burden on the public, who ultimately pay the price for maintaining a stable financial system Taxpayers now face both hidden costs, like deposit insurance, and explicit costs associated with bailing out systemically important institutions, making the situation increasingly detrimental and costly for society as a whole.

Too-Big-to-Fail as Banking Pollution

The 'too-big-to-fail' (TBTF) doctrine, first mentioned in the early 1960s and officially recognized in 1984 during the bailout of Continental Illinois National Bank, has come under scrutiny since the global financial crisis (GFC) of 2007–2009 Critics argue that TBTF policies exacerbated the crisis, leading policymakers to acknowledge that the costs may outweigh the benefits Since 2011, the Financial Stability Board (FSB) has designated 28 to 30 large banks as global systemically important banks (G-SIBs), which we refer to as 'G-SIBs' for simplicity The public bailouts of these banks highlighted significant taxpayer costs and shifted the discussion from academia to mainstream media, revealing the large-scale systemic risks accumulated by banks due to implicit government guarantees (IGGs).

Government interventions can disrupt the natural balance of market forces related to risk and return Similar to various insurance contracts, these interventions lead to moral hazard issues, particularly in the case of "too big to fail" (TBTF) institutions This results in bank creditors failing to adequately monitor their lending practices, banks engaging in excessive risk-taking, and shareholders being drawn to potentially higher returns without considering the associated risks.

The risk-return profile of Global Systemically Important Banks (G-SIBs) reveals that increased risk can lead to overproduction, heightened volatility, and a greater likelihood of bank failures This systemic importance raises the chances and severity of financial crises, economic cyclicality, and associated output losses A significant aspect of this issue is the funding differences among G-SIBs, driven by creditors' moral hazard due to implicit government guarantees (IGGs), which result in substantial indirect benefits amounting to hundreds of billions of dollars annually, ultimately borne by the public Consequently, the indirect costs of being "Too Big To Fail" (TBTF) appear to outweigh the direct costs The Global Financial Crisis (GFC) illustrated that transferring liabilities from G-SIBs to governments can place an overwhelming burden on public finances, as seen in Iceland, thereby destabilizing the entire financial system.

The systemic risk externality posed by Global Systemically Important Banks (G-SIBs) represents a significant market failure, resulting in economic inefficiencies that impose unwanted costs on taxpayers This phenomenon can be likened to "banking pollution" within the framework of environmental economics.

Regulation of Too-Big-to-Fail

The concept of the "invisible hand" in economics is influential, yet it has its limits Scholars advocate for the abolition of "Too Big to Fail" (TBTF) institutions to alleviate the financial burden on future generations and to enforce market discipline among banks While complete elimination may be extreme, exploring alternative approaches to address these issues is essential.

The regulation and measurement of 'banking pollution' has gained significant attention from economists, regulators, and central bankers following the global financial crisis (GFC) Alongside monetary and fiscal policies, ensuring the safety and soundness of financial intermediaries has emerged as a critical aspect of public policy Initiatives like the European Banking Union, the Dodd-Frank Act in the USA, and Basel III exemplify efforts to regulate large banks In 2009, G20 countries established the Financial Stability Board (FSB) to enhance global financial regulation for globally systemically important banks (G-SIBs) Each year, the FSB identifies 28 to 30 G-SIBs, which are subject to stringent regulatory requirements, including higher common equity tier 1 capital (CET1), total loss-absorbing capacity (TLAC), and resolvability standards Consequently, these major global banks are required to raise over €1 trillion in equity and special debt by 2022.

However, more drastic approaches seem to be off the table, such as the suggestion Bernie Sanders made during his 2016 presidential campaign that any bank deemed

4 International Monetary Fund (IMF) (April 2014).

9 Hale, Binham, and Noonan (9 November 2015).

1.1 General Context and Current Developments

The concept of "Too Big to Fail" (TBTF) should be dismantled, as a decade after the Global Financial Crisis (GFC), the global economy has flourished and TBTF has faded from public discourse Some banking industry leaders assert that TBTF is "essentially solved," while governments worldwide exhibit "regulatory fatigue" and contemplate rolling back stringent regulations on major banks, particularly in the United States On June 8, 2017, the US House of Representatives passed the Financial CHOICE Act, which aims to repeal significant aspects of the Dodd-Frank Act if implemented Additionally, the Basel Committee has postponed new banking policy initiatives until 2019.

Bank Stock and Valuation Trends

During the Global Financial Crisis (GFC), the stock market experienced a significant decline, as illustrated in Figure 1.1 Bank stocks were particularly hard hit due to their reliance on the real economy and their substantial exposure to subprime mortgage securities, leading to a more severe drop compared to broader indices like the Dow Jones Industrial Index and Euro Stoxx Consequently, the recovery of bank stocks was notably slower than that of these broader market indices.

Bank valuations, measured by the price-to-book value (P/BV) ratio, have remained notably weak, failing to recover to pre-GFC levels This reflects a structural shift in the banking sector, often termed 'the new normal.' A key factor in this change is the decline in return expectations (RoE), which have been impacted by increased capital requirements.

10 Cf Jopson, Weaver, and McLannahan (8 April 2016).

The dilution of capital requirements has risen alongside a low-interest environment, which serves as a fiscal response to the economic downturn, compounded by higher regulatory costs Despite enhanced capital buffers, the cost of equity (CoE) for investors has escalated, reflecting greater shareholder liabilities and increased uncertainty surrounding bank profitability and regulation Additionally, growth expectations have diminished as banks focus on de-leveraging their balance sheets and divesting non-core activities.

Research Objective and Methodology

Part I—Too-Big-to-Fail in Banking Review

Following the Global Financial Crisis (GFC), extensive academic research has focused on the concept of "Too Big to Fail" (TBTF), resulting in hundreds of studies and over a dozen PhD dissertations examining various aspects of this critical issue.

Kleinow (2016, 3–10) provides an extensive analysis of thirteen PhD monographs addressing the concept of "Too Big To Fail" (TBTF) The research is organized into four key categories: the development of systemic risk measures, the study of international financial contagion, the identification of systemically important banks, and the regulation of these institutions.

Prominent scholars have authored books to share the narrative of "Too Big to Fail" (TBTF) with the general public However, a small segment of the academic community remains skeptical about the significance of TBTF and its influence on financial crises In contrast, the majority of financial experts assert that recent regulatory measures have effectively addressed the TBTF issue.

Part I of this dissertation aims to address a significant gap in the academic literature on "Too Big To Fail" (TBTF) by integrating broad perspectives with recent findings from specialized studies It argues that the costs associated with TBTF surpass its benefits and illustrates how Global Systemically Important Banks (G-SIBs) can internalize the costs of implicit government guarantees (IGGs) to achieve a socially optimal outcome.

Hence, the overall research question is:

Should TBTF in banking be abolished? And if so, how?

This interpretive literature review and qualitative study examines the concept of "Too Big to Fail" (TBTF) from multiple perspectives, focusing on the evolution of systemic risk in the financial system and its impact on the banking landscape It explores how distortions caused by implicit government guarantees (IGGs) expose moral hazards among creditors, shareholders, and bank management Additionally, the study reviews proposed regulatory measures aimed at curbing TBTF and concludes with normative insights on the potential dissolution of the TBTF doctrine.

Part II—Quantifying the Shareholder Value of Too-Big-to-Fail in Banking

The impact of "Too Big to Fail" (TBTF) on equity holders has been largely overlooked in both theoretical and empirical research While studies have shown that TBTF influences the behavior of bank creditors and results in significant funding advantages for banks due to moral hazard, the effects on equity holders are less clear and more challenging to quantify.

Numerous share-price event studies reveal that specific events related to the Too Big to Fail (TBTF) doctrine significantly affect the stock prices of major banks For instance, research indicates that institutions like the Continental Illinois National Bank and Trust Company have experienced notable stock fluctuations in response to these events.

Recent studies indicate that events related to "Too Big to Fail" (TBTF) have led to both positive and negative abnormal share-price reactions for financial institutions While earlier research highlighted positive share-price responses, subsequent analyses have expanded to include various regulatory events impacting newly designated Global Systemically Important Banks (G-SIBs) However, a comprehensive understanding of how these diverse factors collectively influence the overall share prices of G-SIBs remains insufficiently explored.

13 Most notable is the popular but in part outdated book by Stern and Feldman (2009b).

The valuation of Global Systemically Important Banks (G-SIBs) can be distorted by various factors, making it insufficient to rely solely on long-term share price analysis Understanding the influences on G-SIB valuation is crucial for both regulators and shareholders, as it can reveal insights into systemic risk and financial stability A potential valuation premium may indicate heightened systemic risk, while also reflecting the financial strength of G-SIBs Conversely, a valuation discount could motivate shareholders to consider breaking up a bank.

What drives the valuation of stocks of G-SIBs compared to stocks of other banks over time?

This empirical study utilizes the price-to-tangible common equity (P/TCE) ratio to evaluate bank valuations, serving as an enhanced alternative to the price-to-book value (P/BV) ratio The Global Systemically Important Banks (G-SIBs) are identified based on designations from the Financial Stability Board (FSB) To account for external factors beyond the "too big to fail" (TBTF) designation, various input factors related to profitability (Return on Equity - RoE), risk (Cost of Equity - CoE), and growth (g) have been analyzed The research encompasses an extensive dataset of quarterly observations from over 750 global banks, covering an unprecedented period from Q2 2008 to Q3 2015, which includes the timeline before the FSB's establishment on November 17, 2008, and prior to the European Banking Authority's (EBA) first publication of other systemically important institutions (O-SIIs) on April 26, 2015.

2016 This period spans several relevant designation and regulation events for G-SIBs

To identify entity- and time-fixed effects (i.e valuation developments of a subset of banks per quarter), a two-way fixed-fixed regression model is applied.

Dissertation Structure

The following provides an abstract of each part and chapter in order of the agenda The dissertation starts with two introductory chapters.

Chapter 1 provides an overview of the concept of "Too Big to Fail" (TBTF) in the banking sector, outlining two key research questions and the dissertation's overall structure It highlights the current context and recent trends in bank stock valuation since the Global Financial Crisis (GFC), identifies existing gaps in TBTF research, and establishes the research questions and methodologies to be explored.

Chapter 2 delves into the concept of "Too Big to Fail" (TBTF) and outlines key research questions, beginning with a clear definition of a bank and an explanation of fundamental banking principles It emphasizes the critical role banks play in the economy by summarizing essential banking economics The chapter establishes a causal relationship between banking risk, bank runs, panic, and widespread economic crises It also discusses historical measures intended to prevent such crises, which have inadvertently encouraged TBTF through increased risk-taking, specifically highlighting deposit insurance and ineffective failure-resolution policies Finally, the chapter addresses how moral hazard among banks and creditors necessitates stringent bank regulation.

Part I—Too-Big-to-Fail in Banking Review

The second part of this dissertation consolidates existing academic research on "Too Big To Fail" (TBTF) in banking, examining its historical context and future policy recommendations Chapter 3 defines TBTF and assesses systemic risk as its underlying cause, while also exploring significant historical events that have shaped the evolution of TBTF over time.

Chapter 4 explores the theoretical aspects of the "Too Big To Fail" (TBTF) phenomenon, examining the motivations behind banks' desire to achieve TBTF status It highlights the role of explicit government guarantees (EGGs), or bailouts, for globally systemically important banks (G-SIBs), and analyzes how implicit government guarantees (IGGs) contribute to moral hazard among creditors, banks, and shareholders.

Chapter 5 examines the welfare implications of the "Too Big to Fail" (TBTF) doctrine, highlighting it as a significant negative externality and a key contributor to market failure and inefficiencies within the banking sector The chapter includes a cost-benefit analysis that assesses the effectiveness of regulatory measures aimed at addressing the TBTF issue.

Chapter 6 summarises bank-level policy recommendations for G-SIBs by academics and policymakers in reaction to the GFC, categorized chronologically into crisis prevention, crisis management, and crisis resolution recommendations.

Chapter 7 outlines key policy initiatives addressing institutions deemed "too big to fail" (TBTF) since the Global Financial Crisis (GFC) It highlights the European Banking Union, the Dodd-Frank Act in the United States, and Basel III regulations Additionally, it emphasizes the Financial Stability Board (FSB) regulation, which stands out as the sole global effort specifically aimed at mitigating TBTF risks.

Chapter 8 wraps up Part I of the dissertation by summarizing the key points from each chapter and offering insights into the future of the "Too Big to Fail" (TBTF) doctrine and its regulation, emphasizing the need for significant reform.

Part II—Quantifying the Shareholder Value of Too-Big-to-Fail in Banking

This part presents the empirical analysis of the dissertation, which measures the relative equity valuation differences of G-SIBs This part is structured like a standard research paper.

Chapter 9 provides a comprehensive overview of the literature examining the influence of "Too Big to Fail" (TBTF) on stock prices and market equity, highlighting key findings and methodologies Additionally, it explores existing research on bank valuation techniques and regression models used in this context.

Chapter 10 develops hypotheses about the research question and the applied methodology.

Chapter 11 details the data and empirical model utilized in the regression analysis, providing a thorough explanation of each input variable It also outlines the data extraction process and describes the characteristics of the sample Additionally, the chapter demonstrates that the study adheres to all formal requirements necessary for a robust regression analysis.

Chapter 12 presents the findings for each regressor, focusing on the development of the G-SIB dummy It draws conclusions from the empirical data and proposes directions for future research.

Chapter 13 concludes Pt II of the dissertation It summarises the key findings and implications and deduces recommendations for bank management and policymakers.

11 © The Author(s), under exclusive license to Springer Fachmedien Wiesbaden GmbH, part of Springer Nature 2021

T F Lesche, Too-Big-to-Fail in Banking, Finanzwirtschaft, Banken und Bankmanagement

I Finance, Banks and Bank Management, https://doi.org/10.1007/978-3-658-34182-4_2

This chapter provides a general foundation for the following chapters about the too-big- to-fail (TBTF) problem in banking, defining relevant banking terms necessary for general understanding.

This overview of banking microeconomics highlights the significance of transaction costs and information asymmetries in understanding the financial system Key theories from new institutional economics, such as transaction cost theory, principal-agent theory, and property rights theory, provide valuable insights into these issues.

The chapter highlights the crucial role of banks in capital allocation within the economy, emphasizing their importance in the financial system It defines 'bank' and outlines essential accounting concepts for the study's empirical analysis The discussion addresses the threat of bank runs, which can lead to significant bankruptcy costs Furthermore, it explains deposit insurance and the lender of last resort (LOLR) as measures to mitigate the impact of bank runs, while also acknowledging the moral hazards they introduce The chapter details the progression from bank runs to banking crises and ultimately financial crises, underscoring the necessity for bank regulation, which is further explored through an overview of regulatory instruments.

A Primer for Economics of Banking 2

2 Jensen and Meckling (1976) and Eisenhardt (1989).

3 Demsetz (1967) and Grossman and Hart (1986).

12 2 A Primer for Economics of Banking

Financial System

A well-functioning financial system is crucial for promoting economic growth and efficiency by channeling surplus funds from lenders, primarily households and firms, to borrowers, including firms, governments, and households Financial intermediaries, such as banks, mutual funds, private pension funds, and insurance companies, play a key role in this process, operating within regulated financial markets This system ensures that those without productive investment opportunities can connect with those who do, facilitating a smooth flow of funds and contributing to overall economic stability.

Financial intermediaries and financial markets share a commonality in offering specialized services that achieve much greater economies of scale and scope compared to direct bilateral contracts between lenders and borrowers.

They perform three main functions: 7

5 Shadow banking system is the term used for non-bank financial institutions that provide traditional banking services.

6 Cf Mishkin (1996, 2), Mishkin (2004, 375–76), and de Haan, Oosterloo, and Schoenmaker

7 Cf de Haan, Oosterloo, and Schoenmaker (2015, 3).

Fig 2.1 Flows of Funds Through the Financial System (Source: Mishkin (2004))

4 Cf Bernanke (1983), Calomiris, James, and Stock (1986, 488), Freixas and Rochet (2008, 7), Friedman and Schwartz (1963), and Gilbert and Kochin (1989, 333) for western world, and Mishkin (1996) for the emerging markets.

A financial system plays a crucial role in minimizing transaction costs by facilitating the transfer of property rights between lenders and borrowers with legal certainty It standardizes financial contracts and enables financial intermediaries to manage lendings and borrowings on their balance sheets However, the presence of laws, rules, customs, and norms can create friction within the system, particularly due to transaction technology limitations such as indivisibilities and non-convexities Financial intermediaries complement financial markets by effectively reducing costs associated with these imperfections and economic frictions.

A robust financial system enhances liquidity and facilitates risk-sharing by offering diverse lending and borrowing options, allowing participants to diversify and mitigate risks It plays a crucial role in minimizing the risk of illiquidity, which can adversely impact consumption and investment In the absence of such a system, lenders would be confined to illiquid long-term loans Financial markets contribute to liquidity by bringing together sufficient buyers and sellers for standardized financial contracts, while financial intermediaries maintain a portion of liquid assets on their balance sheets to address liquidity demands effectively.

Minimizing costs linked to information asymmetries is vital for the efficient operation of financial systems Asymmetric information can occur before (ex-ante) and after (ex-post) a financial contract is established Ex-ante asymmetry arises when borrowers possess more knowledge about their investment projects than lenders, leading to adverse selection and potential market failure To mitigate this risk, lenders often employ borrower screening Conversely, ex-post asymmetry creates moral hazard risks, as borrowers may not disclose how they utilize borrowed funds, necessitating control measures to uncover hidden intentions Additionally, only borrowers can track the progress of their projects, making monitoring essential to reveal covert actions and undisclosed information Financial markets and intermediaries work to minimize the costs associated with these screening, controlling, and monitoring processes.

Financial Markets vs Banks vs Non-Bank Financial Intermediaries

When evaluating financial markets and financial intermediaries, three crucial questions arise: which system is more effective, which fosters greater innovation, and which contributes to enhanced economic growth and stability.

8 According to Freixas and Rochet (2008, 16, 18).

9 de Haan, Oosterloo, and Schoenmaker (2015, 11).

10 According to Freixas and Rochet (2008, 20–24).

12 This situation is similar to the textbook example of the market of lemons (Akerlof (1970)).

13 Cf Mishkin (1996, 2) and Freixas and Rochet (2008, 17, 30).

14 The market-based system is predominant in the Anglo-American countries, while the bank-based system is in countries like Germany of Japan.

Financial markets and financial intermediaries play distinct roles in addressing information asymmetries within the financial system Financial markets excel at minimizing costs associated with ex-ante information asymmetries, while financial intermediaries are more effective at resolving ex-post information asymmetries Additionally, financial markets may encounter a free-rider problem in their controlling and monitoring functions.

When market participants who do not invest in information access data paid for by others, it leads to a lack of adequate information acquisition This dynamic results in financial markets becoming more passive, diminishing their ability to mitigate incentives for post-transaction moral hazards.

Non-public controlling and monitoring are key advantages of financial intermediaries, particularly banks, which have a stronger motivation to serve as delegated controllers and monitors With significant 'skin in the game' due to their equity investment in each loan, banks face substantial monetary risk This 'first-loss piece' provides a powerful natural incentive for banks to ensure responsible lending practices.

Academic research presents varying opinions on the optimal allocation of funds within financial systems Some studies suggest that financial intermediaries are more effective in emerging financial systems due to information asymmetry, while financial markets excel in developed systems Conversely, other researchers propose that financial markets and intermediaries should be viewed as complementary forces rather than competing alternatives.

Introduction to Banks

A bank is a financial institution whose main operation is to grant longer-term loans funded principally by demand deposits by the public 22

According to Dermine (2014), there are five key economic motivations for risk management in banks: (i) the self-interest of management, (ii) the non-linear nature of taxes, (iii) the costs associated with financial distress, (iv) imperfections in capital markets, and (v) the reliance on short-term deposits for funding.

20 Cf empirical research conducted by Tadesse (2002).

21 Cf Degryse, Kim, and Ongena (2009, 9), Mishkin (1996, 4–5), Levine (2002), de Haan, Oosterloo, and Schoenmaker (2015, 19), and Allen, Carletti, and Gu (2015, 39).

22 Similar to Freixas and Rochet (2008, 1).

15 This simple definition has several important implications:

Banks assume risks when lending money to others to generate returns, engaging in what are known as 'on-balance-sheet activities.' This means that the risk of default persists until the loan is fully repaid.

Banks primarily fund only a small portion of loans with their own equity, resulting in significant leverage This reliance on borrowed funds contributes to greater volatility in returns and limits their capacity to absorb losses, making banks inherently fragile.

Banks primarily fund long-term loans using demand deposits, creating a mismatch in maturities that increases the risk of illiquidity This fundamental issue contributes to the inherent fragility of banks.

To ensure that their deposits are invested securely, the public often seeks firms that operate with transparency and trustworthiness Consequently, the use of the term "bank" in a company's name typically requires a banking license from a national regulatory authority.

In this dissertation, the term "bank" is consistently used in place of less specific terms like financial institution or firm Within the financial system, depositors and creditors are identified as lenders or savers, while debtors are recognized as spenders.

Banks play a crucial role in the economy by fostering essential relationships with borrowers and lenders, built over time through the exchange of unique information that enables efficient loan monitoring They provide vital services categorized into four main functions: facilitating access to payment systems, transforming assets, managing risk, and processing information to monitor borrowers Additionally, banks engage with financial markets by offering services such as underwriting securities, further enhancing their significance in the economic landscape.

Banks, like all businesses, must adhere to accounting standards, specifically the Generally Accepted Accounting Principles (US GAAP) in the United States and the International Financial Reporting Standards (IFRS) utilized globally.

24 Cf Allen, Carletti, and Gu (2015, 42).

The key differences between US GAAP and IFRS lie in their treatment of derivatives and the scope of consolidation US GAAP reports derivatives using net figures, while IFRS employs gross or notional amounts Additionally, US GAAP permits certain assets to remain off-balance sheet, whereas IFRS typically requires these assets to be included on the balance sheet.

Banks differ significantly from other service providers due to their unique operations and financing structures Their assets primarily consist of legal titles, such as loan agreements and securities, which carry a distinct risk profile compared to tangible assets Unlike non-banks, which rely on funding to grow, banks integrate their financing structure as a core component of their business model.

Structure of a Bank’s Financial Statement

The financial statements of banks differ significantly from those of non-banks, yet banks maintain a uniformity in accounting standards globally Typically, the structure of a bank's financial statements features interest-earning assets, such as loans and securities, listed on the right side of the balance sheet in order of liquidity Conversely, liabilities and equity, which fund these assets, are displayed on the left side, also organized by liquidity Interest-bearing liabilities primarily consist of deposits and borrowings A simplified bank balance sheet, highlighting these key components, is illustrated in Figure 2.2.

Fig 2.2 Simplified Bank Balance Sheet

26 KPMG (June 2011)) provides a comprehensive guide to the structure of banks’ financial statements in accordance with IFRS.

Banks typically follow three key strategies in their funding approach: they aim to diversify their funding sources to mitigate the risk of losing any single source, prioritize retail deposits as their primary financing method due to their cost-effectiveness and stability, and strive to align the maturities of their loans with their funding durations before resorting to derivatives.

Interest income and interest expenses represent the primary revenues and costs on a bank's income statement, which is also known as the profit-and-loss statement (P&L) This statement, depicted in a simplified format, highlights that banks primarily engage in loan-lending activities funded by deposits Additionally, banks participate in off-balance sheet activities, which include banking services that generate fees, trading, or commission income without incurring credit risks.

Fig 2.3 Simplified Bank Income Statement

Valuing banks requires a different approach than traditional corporate valuation While non-bank valuations typically start with calculating the enterprise value and then deducting liabilities to find equity value, banks are best valued using methods that derive equity value directly This distinction arises due to the unique financial structures and operational characteristics of banks.

The banking industry is subject to strict regulations that require banks to maintain substantial loan-loss reserves and capital to cover both anticipated and unexpected losses As a result, the ability to pay dividends to shareholders serves as a more accurate reflection of real profits than earnings alone, making it a crucial factor for valuation assessments.

Bank Run, Bank Panics, Systemic Risk and Bankruptcy

A bank run occurs when creditors perceive a threat of insolvency, leading to irrational market behavior driven by beliefs about the actions of other creditors To combat adverse selection and moral hazards, banks monitor borrowers both before and after granting loans However, this process creates an asymmetric information problem, as lenders often lack knowledge about the quality of loans, making them hesitant to deposit money The sequential service constraint in banking incentivizes creditors to withdraw their funds quickly, resulting in a first mover advantage, where institutional creditors typically act before retail depositors Consequently, the inherent fragility of banks makes them susceptible to frequent runs.

A bank run occurs when depositors withdraw funds en masse, leading to a significant depletion of liquidity reserves As access to the interbank market becomes restricted, banks may resort to costly fire sales, selling assets at prices well below their true value to satisfy depositor demands This situation can persist until the bank's liquidity is entirely exhausted, resulting in insolvency, or until the losses from fire sales deplete all equity, ultimately causing the bank to declare bankruptcy.

In summary, bank runs significantly increase the instability of financial institutions, prompting both banks and regulators to adopt preventive measures One of the most effective strategies for mitigating this risk is the implementation of deposit insurance.

A bank panic occurs when multiple banks experience large-scale runs at the same time, leading depositors to withdraw all their funds in cash instead of transferring them to what they believe to be more stable banks This phenomenon arises when creditors lose confidence in the overall banking system, prompting widespread withdrawals.

42 See Diamond and Rajan (2000), Diamond and Dybvig (1983) and Christiansen (2001, 117).

44 Oliveira, Schiozer, and Barros (2015, 191) present evidence that G-SIBs benefit during times of bank runs by receiving additional deposit inflows from other banks.

2.3 Bank Run, Bank Panics, Systemic Risk and Bankruptcy

45 Cf Bougheas (1999, 131), Brown, Trautmann, and Vlahu (2012, 1), Chari and Jagannathan

(1988, 749), Freixas and Rochet (2008, 217), Freixas (2010, 380) and Temzelides (1997, 3).

Systemic risk is the potential for the failure of a single market participant to trigger widespread negative effects on the entire financial system Unlike idiosyncratic risk, which can be eliminated by maintaining a diversified market portfolio, systemic risk poses a broader threat that impacts the interconnected financial landscape.

There are two ways an institution can exert systemic risk on the financial system: 48

Systemic risk can begin with a localized shock affecting a small number of market participants or a specific sector, which may seem insignificant globally However, the distress or default of these participants can trigger a chain reaction through interconnected financial networks, leading to widespread implications across the financial sector This phenomenon, known as financial contagion or the spill-over effect, illustrates how a micro-level event can escalate to macro-level consequences The overall impact on the financial system hinges on the systemic risk contribution of the involved market participants.

Contagion among banks can happen through four interconnected channels: changes in investor expectations, large-value payment systems, over-the-counter (OTC) operations—primarily involving derivatives—and interbank markets The primary mechanism driving this contagion is the impact of aggregated liquidity shocks.

Systemic sensitivity refers to the impact of macroeconomic events, like natural disasters or changes in bank rates, which can cause significant shocks within the economy As illustrated in Figure 2.5, these top-down shocks progress from the macro level to the micro level, primarily determined by the sensitivity of market participants rather than the transmission of shocks between them.

46 De Bandt and Hartmann (2000) For an overview of the evolution of the term ‘systemic risk’ see Kleinow (2016, 21).

48 Cf Freixas and Rochet (2008, 235) and Allen, Carletti, and Gu (2015, 35–38).

The presence of incomplete markets affects liquidity provision, requiring market participants to maintain liquidity and be prepared to purchase assets from sellers To achieve equilibrium, liquidity providers must be compensated for the opportunity cost of holding liquidity, necessitating sufficient average profits across various states This dynamic leads to significant volatility in asset prices, as highlighted by Allen, Carletti, and Gu (2015).

There are three main explanations for why the banking sector generally tend to be more vulnerable to systemic risks than other sectors: 52

1 The structure of the banks’ balance sheets

2 The complex network of exposures among financial institutions

3 The intertemporal character of financial contracts and related credibility problems.

Standard bankruptcy codes provide for both firm liquidation and reorganization under supervision, but these processes are often ineffective for banks In liquidation, the challenge lies in selling assets quickly after a bank run, as their value typically declines or they become hard to sell Conversely, during reorganization, the difficulty arises from managing liabilities, as uninsured depositors tend to withdraw their funds during times of distress, seeking safer banking options.

Fig 2.4 Bottom-Up Shock or Systemic Risk Contribution (Source: Kleinow (2016))

Fig 2.5 Top-Down Shock or Systemic Sensitivity (Source: Kleinow (2016))

52 According to De Bandt and Hartmann (2000, 6) Cf Hellwig (1998).

53 Both types, for instance, are regulated in Chapters 7 and 11 respectively of Title 11 of the U S Bankruptcy Code.

2.3 Bank Run, Bank Panics, Systemic Risk and Bankruptcy

54 Cf Moyer and Lamy (1992) and French et al (2010a, 13–14).

An economic downturn often leads to the elimination of unproductive banks, but bank runs and panics can inflict significant damage on productive banks, highlighting the need for regulatory oversight rather than reliance on market forces When a bank fails, its stakeholders—including management, equity holders, creditors, account holders, and counterparties—experience varying degrees of loss based on the priority of their claims Additionally, borrowers and the broader economy suffer as the banking sector struggles to perform essential functions effectively Therefore, the timing and scope of regulatory intervention are vital for maintaining the financial system's overall health The direct and indirect costs associated with a bank's bankruptcy are influenced by the orderliness of the liquidation process, which underscores the detrimental impact of a chaotic bank closure on value creation.

The franchise value of banks is significantly influenced by their deep understanding of counterparties, including borrowers and trading partners, as well as their established credit relationships and specialized staff These elements are not easily transferable between banks Consequently, borrowers must invest time in rebuilding trustful relationships with their creditors to regain access to essential loans.

2 Hasty fire sales of illiquid assets may not only reduce prices further, but also spread problems to other holdings of these assets 60

3 A disorderly liquidation increases the general uncertainty about the impact of failure on its competitors, counterparties, and claim holders Such impact can precipitate or intensify a financial crisis 61

Bank Run Prevention and Management

Banks and regulators prioritize avoiding bankruptcy due to its significant costs Historically, two key measures have been implemented to prevent bankruptcy: deposit insurance and the lender of last resort Initially created to protect the banking sector's interests, these measures are now mandated by financial regulators.

57 Cf Diamond and Dybvig (1983, 401), Moyer and Lamy (1992) and Freixas (2010, 380).

58 In accordance with French et al (2010a, 13–14).

60 Shleifer and Vishny (1992) and Shleifer and Vishny (2010).

Bank runs can be effectively prevented by implementing suitable deposit contracts or establishing deposit insurance, which acts similarly to a put option with a strike price matching the promised redemption value This approach offers significant benefits for banks, depositors, and society as a whole, enhancing financial stability and trust in the banking system.

For banks, implementing effective withdrawal policies offers significant advantages, including strong signaling effects that discourage excessive cash withdrawals and the creation of 'sticky funds' that enhance funding stability and reduce uncertainty.

• For depositors: (a) The freedom to withdraw money at all times, also referred to as

‘safe haven’, and (b) it provides fair and equitable treatment to depositors—eliminat- ing the first-mover advantage 63

Promoting economic efficiency, this approach minimizes the risk of dangerous contagion effects, while also safeguarding the welfare of private savers with limited asset diversification Consequently, it encourages individuals to save more for their retirement.

In summary, deposit insurance is recognized as the most effective measure to prevent bank runs, leading to its mandatory implementation by law or direct government guarantees for deposits, often utilized in combination.

Management: the Lender of Last Resort

In the event of a bank run or significant cash withdrawals, if a bank cannot secure liquidity from the interbank market, a financial crisis has already emerged During this critical period, the lender of last resort (LOLR) steps in to provide temporary protection for banks.

63 Cf Diamond and Dybvig (1983) and Samartin (2003, 977).

64 Cf U.S Congressional Budget Office (January 1992).

Federal deposit insurance was first introduced in the United States in 1933 and gradually expanded to seven countries over the next three decades By 1974, this system had reached twelve countries, and by 1999, it was implemented in 71 countries As of the early 2000s, nearly 90 countries had adopted mandatory deposit insurance, becoming a standard practice worldwide, particularly in the aftermath of the global financial crisis of 2007–2009.

Post-crisis, deposit insurance coverage has notably increased, with the FDIC in the US insuring deposits up to $250,000 and Germany's 'Einlagensicherungsfonds' offering coverage based on 20% of banks' regulatory book equity per customer, effectively providing extensive protection Research indicates that countries with poorly capitalized banks and less educated depositors tend to have significantly higher average coverage (Laeven, 2004) For a comprehensive overview of global deposit insurance schemes, refer to Demirgỹỗ-Kunt, Kane, and Laeven (2014).

2.4 Bank Run Prevention and Management

Central banks serve as lenders of last resort (LOLR) to provide liquidity support during financial crises, accepting illiquid securities or loans as collateral This liquidity insurance acts as a safety net to reduce the risk of bankruptcies and associated disruptions There are two primary types of LOLR: one as a monetary policy action that lends to all banks during systemic events, and the other as emergency assistance to individual banks facing issues The latter poses challenges, as LOLR must balance being too lenient, which could encourage excessive liquidity risk, against being too strict, which could undermine confidence in the banking system Additionally, it is crucial for LOLR to quickly differentiate between solvent banks at risk of insolvency and unprofitable banks likely heading towards bankruptcy, as supporting the latter could lead to the rise of 'zombie banks.' Allowing inefficient banks to persist can also lead to aggressive competition against more efficiently managed institutions.

Creditor and Bank Moral Hazard

Depositor insurance and the Lender of Last Resort (LOLR) serve as safeguards against illiquidity, aiming to stabilize banks However, like all insurance contracts, they introduce potential moral hazards, particularly when premiums do not reflect individual risk levels Traditionally, these measures are relatively fixed and do not consider the specific assets of banks.

Creditor Moral Hazard (Decreased Monitoring)

Depositors and agents often lack strong incentives to effectively monitor a bank's activities, risk-taking, and liquidity reserves, as they perceive their deposits as secure due to deposit guarantees and the availability of funds through the Lender of Last Resort (LOLR) This reliance on deposit insurance creates a moral hazard, particularly in countries with weak law enforcement, where it undermines private monitoring and leads to inadequate government oversight of banks.

69 Cf Naqvi (2015) This potential weakness of the LOLR was first noted in the seminal work by Bagehot (1873).

70 Kane (1987) invented this term in connection with the capital forbearance of the Federal Savings and Loan Insurance Corporation (FSLIC) during the savings and loan (S&L) crisis (see Sect 3.4.4).

Banks with weaker credit ratings often offer higher deposit rates due to fixed deposit insurance premiums This leads retail and institutional depositors to engage in deposit insurance arbitrage, shifting their funds to the weakest bank that provides the highest interest rates within the insured limit.

Bank Moral Hazard (Increased Risk-Taking)

The moral hazard problem in banking arises from depositors' lack of information regarding the quality of banks' assets This issue is exacerbated by deposit insurance, which encourages banks to take on riskier assets.

1 Monitoring by the depositors is limited (see above).

In the event of a bank default, deposit insurance provides depositors with a par value put option, which leads them to accept lower deposit rates in exchange for this protection Consequently, banks receive minimal price signals from depositors, limiting their ability to gauge investment risk, resulting in interest rates that are largely disconnected from the actual risk involved.

3 Deposit insurance premiums do not increase proportionally with risk-taking, i.e the risk is shared among all banks that pay into the insurance scheme.

In the event of potential failure, banks can rely on deposit insurance or government intervention to mitigate accumulated losses, thereby preventing further losses and the risk of contagion from bankruptcy.

Insured banks tend to be less capitalized and liquid compared to their counterparts, leading to increased risk-taking behavior Insurance encourages these banks to adopt riskier asset portfolios, such as high-risk real estate loans and off-balance sheet activities, which can exacerbate systemic risks within the banking system Similarly, the Lender of Last Resort (LOLR) functions as a safety net but may inadvertently promote excessive liquidity, prompting bank managers to underestimate risks and act more aggressively Prior to extending liquidity, the LOLR evaluates these risks carefully.

74 Cf Wittkowski ((9 March 2016) Cf Garcia (1999), Kane (1986, 175), Demirgỹỗ-Kunt, Kane, and Laeven (2008, 435), and Gropp and Vesala (2004, 571) for discussions on the optimal design of deposit insurance to minimise creditor moral hazard.

2.5 Creditor and Bank Moral Hazard

78 Penati and Protopapadakis (1988, 107) and Moyer and Lamy (1992).

The economics of banking highlights that the contagion and bankruptcy costs associated with bank failures tend to rise with the size of the institution Consequently, the establishment of a Lender of Last Resort (LOLR) often favors larger banks with weaker fundamentals over smaller, well-functioning banks This dynamic creates an incentive for banks to expand to a size that qualifies them for LOLR support, which raises concerns about the stability and health of the banking system.

Deposit insurance and the Lender of Last Resort (LOLR) were created to enhance banking market stability However, while they partially achieve this goal, they can also lead to instability by reducing creditor monitoring and encouraging riskier behavior among banks, which increases the likelihood of investment losses and ultimately results in more bank failures.

In the years leading up to a financial crisis, deposit insurance can have a destabilizing effect; however, during the crisis itself, countries with deposit insurance tend to experience lower bank risk and greater systemic stability Ultimately, the destabilizing impact of deposit insurance before a crisis outweighs its stabilizing benefits during turbulent periods.

Financial and Economic Crises

Crises arise from intricate and evolving relationships among numerous factors, making them difficult to predict and manage This chapter aims to identify and analyze the key elements that influence financial and economic crises.

Banking Crisis or Financial Crisis

Financial crises include banking crises, sovereign debt crises, or currency crises 84 The focus here is on banking crises, which ‘are often also labeled financial crises in the

81 Cf Tucker (27–28 May 2009) with regard to the financial crisis of 2007–2009 and Sect 3.4.2 to earlier historical experiences.

Research by O’Driscoll, Jr (1988) and Demirgỹỗ-Kunt and Detragiache (2002) demonstrates that deposit insurance may lead to bank failures, potentially resulting in a broader banking crisis This finding is supported by the works of Tasca, Mavrodiev, and Schweitzer (2014) as well as Wheelock and Kumbhakar (1995).

It is worth mentioning, however, that technically inefficient banks are more likely to fail than the technically efficient ones (Wheelock and Wilson (1995, 689)) Demirgỹỗ-Kunt and Detragiache

A study conducted in 2002 revealed that the likelihood of banking crises is significantly linked to deregulated deposit interest rates and insufficient institutional oversight Additionally, it was found that the negative effects of deposit insurance on bank stability are more pronounced when the coverage is extensive, the scheme is funded, and when it is managed by the government rather than the private sector.

83 Anginer, Demirgỹỗ-Kunt, and Zhu (2014b, 312).

84 Willett and Wihlborg (2013) provide an analysis on these three types.

In recent centuries, banking crises have exhibited similar patterns, although government responses and the severity of these crises have differed A simplified illustration of the classical sequence of events leading to a financial crisis is presented in Figure 2.6.

Macroeconomic shocks significantly exacerbate adverse selection and moral hazards in financial markets, primarily driven by three factors: rising interest rates, increased uncertainty, and the collapse of asset bubbles Higher interest rates lead to credit rationing, as lenders become more likely to offer loans to bad credit risks while good credit risks withdraw from borrowing Additionally, uncertainty stemming from events like the failure of a Global Systemically Important Bank (G-SIB) or political instability intensifies information asymmetry, further worsening adverse selection and reducing lending activity Lastly, when asset bubbles burst and stock markets decline, the deterioration of firms' balance sheets makes lenders hesitant to extend credit, as declining collateral values increase the potential severity of loan losses This decline in asset value also encourages borrowers to engage in riskier projects, knowing their losses may be less impactful in urgent situations.

Market shocks lead to a decline in asset prices, reducing the appeal for lenders and resulting in bankruptcies among leveraged banks This breakdown of the payments mechanism and the inability to generate credit trigger a decline in investment and overall economic activity.

86 Following Mishkin (1996, 26) See also Mishkin (1996, 18–27), Mishkin (2006, 988–89), and Shachmurove (2011, 225).

3 As a consequence of a bank panic (see Sect 2.3), a significant part of the banking sector becomes insolvent 93 Both causes are deeply connected to each other 94

Two main theories explain the origins of bank panics, though distinguishing their origins can be challenging One theory attributes bank crises to fundamental causes linked to the natural business cycle, triggered by macroeconomic instability affecting entire regions or industries In this view, the banking sector's issues arise from creditors and asset quality deterioration rather than depositors The banking sector exacerbates the crisis through credit expansion during economic upswings and contraction during downturns, a phenomenon known as the credit crunch Consequently, a bank panic occurs when depositors react to negative economic news, leading them to withdraw their funds out of concern for their bank's solvency amid worsening business conditions.

The second theory attributes the origins of bank panic to the behavior of depositors, suggesting that such panics can arise spontaneously and are not necessarily linked to the real economy This phenomenon is characterized by random events influenced by mob psychology or mass hysteria, highlighting the unpredictable nature of bank runs.

A bank panic results in a decline in the number of banks, which subsequently drives interest rates higher and reduces banks' ability to facilitate financial intermediation Consequently, the financial system struggles to allocate funds to the most productive investment opportunities, ultimately defining the characteristics of a financial crisis.

5 Again, ‘the increase in adverse selection and moral hazard problems then lead to a decline in investment and aggregate economic activity’ 101

94 Cf de Haan, Oosterloo, and Schoenmaker (2015, 47–48).

98 Cf Jacklin and Bhattacharya (1988), Ramirez and Shively (2012, 433), and Allen and Gale (2004).

99 Cf Kindleberger and Aliber (2005) and Allen, Carletti, and Gu (2015).

A crisis can be triggered by irrational market behaviors, including trend-driven herding and risk-shifting tendencies among participants, as well as by accounting standards that directly reflect fair value losses.

The financial crisis triggers an economic downturn due to the banking sector's failure to fulfill its essential roles in the economy A recession is technically defined by two consecutive quarters of negative GDP growth Historical evidence indicates that real economy recessions are typically linked to banking market failures, as seen during the Great Depression and the global financial crisis of 2007–2009 Consequently, many economists agree that sustainable economic growth relies on a robust financial market.

Too-Big-to-Fail in Banking Review

The Definition of ‘TBTF’

A bank is deemed "Too Big To Fail" (TBTF) when the government determines that it is essential to protect the nation's financial system and economic stability from potential disruptions This is achieved by guaranteeing the repayment of the bank's uninsured liabilities to prevent the adverse effects of a possible default.

This simple definition has several relevant implications for the presentation of argu- ments in the dissertation:

Introduction to Too-Big-to-Fail in Banking 3

The concept of systemic importance, as defined by the Financial Stability Board (FSB) and Bernanke, highlights the "too-big-to-fail" (TBTF) issue, where the potential collapse of a systemically important financial institution (SIFI) necessitates government intervention to prevent financial instability and economic harm A TBTF firm is characterized by its size, complexity, interconnectedness, and essential functions, which, if compromised, could lead to significant negative repercussions for the broader financial system and economy.

38 3 Introduction to Too-Big-to-Fail in Banking

1 TBTF designation: The government designates a bank as TBTF either ex-ante in an official statement or ex-post by granting government guarantees; the latter process is also called a public bailout As long as there is no official government action, a bank can only be perceived as TBTF by the market.

2 The government’s primary objective: The genuine objective of a bailout (see Sect 4.1.1) is to safeguard the country’s economic growth and stability, which is considered to be greatly dependent on a well-functioning financial system (see Sect 2.1 and Sect 2.6) The government of the country where the bank has its primary operations (and most commonly also its headquarters) decides on whether a bank will be bailed out.

3 The government’s secondary objective: TBTF is not a term coined to address the failure of a single bank, but the potential of one bank to disrupt the entire financial system This potential is known as systemic importance (see Sect 3.3) Factors such as size, complexity or systemic interconnectedness of a bank are considered relevant in assessing the bank’s systemic importance Hence, the secondary objectives of a bailout are: (i) minimizing the risk of financial contagion (see Sect 2.3), which implies that many financial market participants would severely suffer from the defaulting bank liabilities and (ii) re-establishing the stability of the distressed bank and the entire financial sector.

4 The forms of government bailout: A government bails out a bank by at least guaranteeing the repayment of the banks’ uninsured liabilities (see Sect 4.1.3) Equity instruments will not be necessarily guaranteed as it is expected that the holders are better prepared for bearing substantial losses Equity holders may benefit in the second instance by either (i) directly receiving compensation payments as part of the government’s takeover of the bank or (ii) indirectly avoiding bankruptcy due to government bailout.

5 The breach of free market principles: Government intervention on a selective basis in a free market economy results by definition in distortion of market forces and incentives The TBTF doctrine incentivises banks to grow beyond the size of the social optimum and to become designated as TBTF (see Sect 4.2.4) Creditors are less incentivised to monitor the risk of a safe G-SIB, and, in turn, the lack of market feed- back leads to increased bank’s risk taking (see Sect 2.5).

6 The public subsidy of G-SIBs: A TBTF perception or designation will always incur costs for the public An implicit government guarantee results in indirect public subsidies, e.g in form of lower funding costs An explicit government guarantee results in explicit public subsidies, e.g in form of costs for open-bank assistance.

7 Time inconsistency of the decision: When the government bails out a bank or designates a bank as TBTF, it aims to prevent the entire economy from negative externalities This implies that the respective government is led by the assumption that bankruptcy costs, including the costs of a financial crisis, would exceed the bailout costs, including the costs for social costs due to disincentives Such a conclusion, however, is extremely difficult to foresee and to measure ex-ante and even ex-post (see Chap 5).

The Term ‘TBTF’

The term "TBTF," primarily associated with banks, is often discussed in the context of financial institutions throughout this dissertation While it predominantly refers to banks, there are instances of industrial companies being labeled as TBTF The concept is closely linked to the 1984 bailout of Continental Illinois National Bank and Trust Company, although its media usage dates back to 1975 Many scholars consider the Continental Illinois case as the first notable instance of TBTF; however, the groundwork for this concept was established earlier through significant regulatory reforms in the modern banking sector.

The concept of "Too Big To Fail" (TBTF) was largely unknown outside banking circles before 2007, with many economists downplaying its significance or denying its existence However, the substantial bank bailouts during the 2007–2009 financial crisis highlighted the reality of TBTF, dispelling doubts among skeptics and drawing increased attention from academia, regulators, and the public alike Given the widespread economic implications of these bailouts, it is not surprising that TBTF has since prompted the development of specific regulatory policies.

The term "TBTF" can be misleading, as a bank's size is not the primary factor in determining the need for a rescue; instead, it is the bank's systemic importance that could negatively impact the financial system Various terms similar to TBTF exist in literature, each highlighting different reasons for a bailout and the implications for stakeholders Despite these differences, all these terms share a common fundamental definition regarding the critical nature of banks in the financial ecosystem.

2 Cf Leathers and Raines (2004, 4) and Sprague (1988, 4).

In academic literature, several key terms describe the complexities of large financial entities, including "too-complex-to-fail," "too-big-to-liquidate," and "too-big-to-regulate." Other phrases such as "too-systemic-to-fail," "too-connected-to-fail," and "too-political-to-fail" highlight the intricate interdependencies and regulatory challenges associated with these institutions Additionally, concepts like "too-big-to-unwind," "too-big-to-discipline-adequately," and "too-big-to-manage" emphasize the difficulties in effectively managing and overseeing these vast organizations.

The concept of "too big to fail" encompasses various dimensions, suggesting that certain entities are too large or interconnected within the financial system to be allowed to fail without causing significant repercussions These entities are often viewed as too complex to unwind or liquidate and are deemed too important politically and economically, making them immune to prosecution or substantial losses The phrase captures the notion that their sheer size and influence render them untouchable, creating a paradox where their failure could lead to greater systemic risks, while their success may be equally questionable Ultimately, the idea underscores the challenges of managing institutions that are perceived as too big to save or too big to survive.

(2010, 320)), too big to fail and unwind, and too big to discipline adequately (Kane (2000, 673)).3.2 The Term ‘TBTF’

The concept of "Too-Big-to-Fail" (TBTF) in banking refers to institutions deemed essential to the financial system, often categorized as Large and Complex Financial Institutions (LCFIs) or Systemically Important Financial Institutions (SIFIs) These entities play a critical role in the economy, making their stability vital for overall financial health.

‘G-SIB’ will be used throughout this dissertation.

Systemic Importance

Systemic importance, or systematic relevance, refers to the dual aspects of systemic risk: (i) the contribution of financial contagion and (ii) the sensitivity to macroeconomic shocks It is defined as the ability of a financial institution to potentially disrupt the entire financial system through either or both of these risks.

The term systemic importance entered economic jargon long after the term TBTF

Systemic importance, rather than bank size, emerged as a key factor in determining "Too Big to Fail" (TBTF) around 1993 when the FDIC established it as a requirement for bailouts This concept gained renewed attention following the collapse of Lehman Brothers in 2008 Since then, extensive research has highlighted systemic importance as a crucial element for ensuring financial stability.

Systemically important market participants encompass both financial market providers and intermediaries, with banks having the most significant impact on the financial system, followed closely by insurance companies.

Systemic importance pertains to both domestic and global financial systems, highlighting the interconnectedness of national and international entities While national governments and financial regulators focus on matters of domestic interest, the global financial linkages among banks indicate that domestic and international systemic importance are increasingly intertwined.

The establishment of various governmental institutions to monitor systemic risk highlights the significance of the term Notably, the European Systemic Risk Board (ESRB) was created in 2010 to oversee the EU's financial system and mitigate systemic risk Similarly, the Financial Stability Board (FSB) was formed in 2009 at the G20's request to implement global measures aimed at reducing systemic risk In the United States, the Financial Stability Oversight Council (FSOC) was established in 2010 under the Dodd–Frank Wall Street Reform and Consumer Protection Act to address these concerns.

11 Billio et al (2012) and Engle, Jondeau, and Rockinger (2015).

8 Cf De Bandt and Hartmann (2000).

9 Cf Alessandri, Masciantonio, and Zaghini (2015, 5), De Bandt and Hartmann (2000, 6), and Mishkin (2006, 989).

In response to the increasingly international landscape, particularly within large economic regions such as the EU, the Financial Stability Board (FSB) was established to enhance global collaboration among supervisors This initiative aims to mitigate risks associated with the systemic significance of banks.

There is no consensus or definitive definition of systemic importance, as the factors influencing it can vary with each crisis However, it is widely recognized that certain catalysts, such as financial system linkages, impacts on the financial system, standard banking risks, and complexity, significantly contribute to systemic risk These categories often overlap and are interdependent, indicating that the more distinctive a criterion is, the greater its systemic risk impact on the financial system.

Interconnectedness in the financial system increases contagion risk, stemming from significant price movements or defaults of exchanged assets A greater number of linkages between market participants heightens this risk, as closely connected entities have less incentive to sever ties with inefficient participants While these interconnections can enhance diversification and improve risk sharing, they also introduce systemic risk Initially, linkages allow banks to diversify their asset portfolios and reduce exposure to idiosyncratic risk, making the financial system more resilient to liquidity needs during stable times.

Banks maintain direct balance sheet linkages through interbank deposits and the exchange of securities, typically involving short-term maturities Given their status as well-informed market participants, there exists a risk of a complete cessation of interbank lending.

Indirect linkages in banks' balance sheets occur when they possess similar assets that experience identical price fluctuations When banks maintain comparable portfolios, it can lead to market liquidity issues.

12 Cf Alessandri, Masciantonio, and Zaghini (2015, 6).

15 De Bandt and Hartmann (2000, 6) present a comprehensive literature review encompassing both the theoretical models and empirical evidence on the concept of systemic risk.

16 Cf Cifuentes, Ferrucci, and Shin (2005).

The concept of "Too-Big-to-Fail" in banking highlights the risks associated with simultaneous asset liquidation by multiple banks, which can lead to significant volatility in financial markets This volatility is exacerbated by the fair-value accounting method, where trading assets are recorded at market value on balance sheets As banks are compelled to acknowledge unrealized losses, they may engage in cyclical behavior, resulting in the hurried sale of distressed assets, ultimately impacting their profit and loss statements.

Banks establish direct connections with capital markets, utilizing both bilateral funding and refinancing through debt and equity markets They also invest in securities for liquidity management and trading strategies Unlike traditional retail depositors, capital market participants are more informed and make quicker decisions, often with shorter maturities, frequently on an overnight basis This combination of factors heightens the risk of institutional bank runs.

Banks leverage financial innovations like securitizations to shift credit risk to capital market participants, thereby diversifying their risk exposure They also facilitate capital markets by underwriting corporate securities and ensuring adequate market liquidity through market-making activities Additionally, banks serve as direct counterparties by issuing financial derivatives to their clients.

Cross-border linkages refer to the interconnectedness of financial operations that transcend national borders, highlighting the complexities of resolvability under varying legal and regulatory frameworks This concept is crucial in distinguishing between domestic and global systemic importance, as balance sheet and capital market linkages are inherently globalized in today's interconnected economy.

• Impact on the financial system: The sub-criteria introduced below describe the potential of a bank to trigger financial contagion should the above linkages exist 24

The size of a bank, measured by its total assets and off-balance sheet exposure, indicates the potential volume of funds available for circulation in the economy.

The History of TBTF

The US as the Prototype of TBTF History

This section outlines the chronology of Too Big to Fail (TBTF) in banking, starting from events that laid its foundation While economists generally agree on the timeline, there are differing opinions on specific dates and the significance of certain occurrences The purpose is to demonstrate the emergence of TBTF and the recurring nature of its implications in history The evolution of TBTF is consistent across Western nations, but European banking history is more fragmented and less documented in English Consequently, the United States serves as a primary example of TBTF, which is the focal point of this overview.

The concept of "Too Big to Fail" (TBTF) has its roots in the United States, recognized for having the most advanced banking system globally For decades, US banks dominated the financial landscape, but it wasn't until the 2007–2009 financial crisis that TBTF gained significant attention in Europe.

The timeline of the Too Big to Fail (TBTF) doctrine begins before 1913, marked by minimal regulation and supervision of US banks Between 1913 and 1933, the banking sector experienced deregulation alongside increased government intervention, creating a fertile ground for TBTF This contradictory regulatory landscape incentivized banks to grow too large, leading to initial significant bailouts Despite earlier regulatory attempts to address TBTF, these efforts were largely forgotten during a period of banking prosperity and stability It was only revealed during the global financial crisis, with its extensive bailouts, that the escalating TBTF risks of the preceding decade had been overlooked.

Before the establishment of a central bank in 1913, the banking landscape for over a century was characterized by 'free banking and the gold standard,' marked by a lack of federal regulation and state-specific banking laws During this period, state oversight and regulation of banks were minimal, leading to significant limitations in banking practices.

39 Sennholz (1992, 427–28) Cf Rolnick and Weber (1982, 18–19).

Leathers and Raines (2004) trace the origins of the concept of "Too Big to Fail" (TBTF) back to the eighteenth century in the UK, highlighting the intricate relationship between the British government and three major private joint-stock companies, including the Bank of England.

46 3 Introduction to Too-Big-to-Fail in Banking that determined the banking environment were the ‘unit banking system’ 40 and the

In the early banking system, banks operated on an 'asset-backed currency' model, leading to their relatively small size and lack of diversification They issued their own currency and accepted checking deposits, allowing customers to write checks or drafts To facilitate transactions, banks established joint clearinghouses for settling balances and providing interbank loans At that time, there was no federal deposit insurance or official lenders of last resort; instead, liquidity support for struggling banks often came from local clearinghouses, funded by member banks.

During this period, the banking sector faced frequent crises, with banks typically operating for only around five years In cases of insolvency, banks were either liquidated at a discount to creditors or acquired by stronger competitors This insolvency not only affected the banking sector but also disrupted the payments system and tightened available credit, leading to negative macroeconomic consequences The most severe crisis occurred during the panic of 1907.

The National Bank Act of 1853 established a unit banking system, which mandated that banking corporations operate from a single office or branch This legislation aimed to limit the influence of out-of-state banks and to provide local banks with a degree of monopoly.

Historically, a legal obligation required that issued bank notes be backed by precious metals, redemption, or state and federal treasuries, with legislation evolving over time Consequently, the government did not control the money supply; rather, it was dictated by trade demands This asset-backed currency system is often cited as a key factor contributing to prolonged deflation and recurring financial crises, as it restricted the ability to increase the money supply during times of crisis, leading to illiquidity (Bernanke and Harold, 1991; Shachmurove, 2011).

The historical data suggests a clearer understanding of the banking crisis sequence, starting with illiquidity and asset devaluation due to banks' reliance on volatile state bonds This instability led banks to recall loans or seek liquidity from other institutions to avoid illiquidity, resulting in seasonal liquidity spikes, particularly during planting season when rural banks withdrew deposits Subsequently, fears of bank instability triggered bank runs among depositors and noteholders Finally, while many banks in certain US states faced closure and significant losses for noteholders, other states managed to maintain a stable financial environment with few bank failures.

3.4.2 The Breeding Ground of TBTF (1913–1933)

The regulatory changes between 1913 and 1933 marked a pivotal moment in the establishment of the "Too Big to Fail" (TBTF) doctrine, primarily driven by two significant banking legislation reforms: the creation of a central bank in the US and the introduction of federal deposit insurance These measures were implemented in response to severe banking crises that led to the gradual abandonment of conventional bankruptcy processes for banks Additionally, the previous restrictions of the 'free banking and gold standard' era, namely asset-backed currency and the unit banking system, were either eliminated or lessened This shift facilitated unprecedented growth in the size and number of US banks during the early 20th century.

The Creation of the Federal Reserve System (1913)

In response to the need for economic stability and regulation in the decentralized banking system, the United States established the Federal Reserve System on December 23, 1913, following the Federal Reserve Act This move was largely influenced by a series of financial panics, notably the severe panic of 1907 As a result, the Federal Reserve became the central bank of the US, abandoning the asset-backed currency principle and taking on the role of lender of last resort.

The major purpose of the Fed was to establish an absolute monopoly over the money supply by monetary policy in a fractional-reserve banking system 45 Bank notes were

In the early 20th century, the expansion of banking corporations in the U.S was limited due to regulations restricting them to a single office However, legislative changes began to emerge, leading to an increase in branch banking By 1900, there were 87 banks with 119 branches, which grew significantly to 397 banks and 785 branches by 1915 This growth stagnated in 1930, with 750 banks operating 3,518 branches The 1933 Glass-Steagall Act further impacted the banking landscape by prohibiting universal banks, aiming to separate commercial banking from investment activities to protect depositors.

‘to underwrite security issues by their low-quality borrowers, and so to ensure that their loans were repaid’ (Morrison (2011, 504–5)).

The establishment of the Office of the Comptroller of the Currency (OCC) in 1863 marked a crucial step in managing the money supply, as outlined in the National Currency Act This initiative was significant during the American Civil War, which lasted from 1861 to 1865, highlighting the need for a stable financial system amidst national turmoil.

The legislation triggered in 1865 aimed to ensure that troops were adequately paid and provisioned The Office of the Comptroller of the Currency (OCC) mandated that banks purchase U.S bonds to back the banknotes they issued, providing a safety net for depositors in case of bank failures Profits from the sale of these bonds would be used to reimburse depositors, while the OCC was established to oversee the safety and soundness of banks at a federal level However, the effectiveness of this oversight remained limited until the establishment of the Federal Reserve.

Explicit Government Guarantees (EGGs) (Bailout)

The government utilizes two primary tools to drive economic growth and stability: monetary policy, which focuses on regulating the money supply and is typically implemented indirectly by central banks, and fiscal policy, which centers on taxation and government spending actions and is executed directly by the government.

This dissertation focuses specifically on the fiscal aspects of bank interventions, particularly the direct bailouts aimed at preventing bank bankruptcies and liquidations It explores the rationale behind government bailouts (Section 4.1.1), identifies the parties involved in the guarantees (Section 4.1.2), outlines the execution process of these bailouts (Section 4.1.3), and examines the impact on various stakeholders.

When extending EGGs to banks, policymakers, including regulators, weigh the expected total costs and benefits of the measure compared to the bankruptcy costs (see Chap 5)

During a crisis, the advantages of EGGs are frequently exaggerated, while their associated costs are minimized, a phenomenon known as time-inconsistency This effect becomes increasingly significant as the severity of the crisis escalates Additionally, Global Systemically Important Banks (G-SIBs) often leverage fear to justify their demands.

General instability of the financial system (risk of bank runs and banking crises)

Subsidy to debt holders Subsidy (or impediment) to shareholders

Increased regulatory pressure for TBTF banks

Increase of put option / charter value of shares

Increase of put option value of debt

Government safety-net for TBTF banks

Deposit insurance LOLR Bailout authority Weak bank resolution mechanism

Fig 4.1 Graphical Illustration of TBTF Causal Chain

Policymakers often serve as representatives for the public, specific governmental institutions, or their own interests From a social-cost perspective, it is essential that they prioritize the needs of taxpayers, who ultimately fund bailouts This approach increases the likelihood of receiving Economic Growth Grants (EGG) while ensuring that the interests of the broader community are considered.

In considering EGG, policymakers may consider the following non-exclusive and interconnected motivations:

1 Economic stability: The reason most often given is to safeguard the country’s economic growth and stability, which is considered greatly dependent on a well-functioning financial system (see Sect 2.1) Hence, the systemic potential of a bank to disrupt the whole financial system is the subordinated objective in this context (see Sect 3.3).

2 Direct credit allocation: This motivation might be present in developing countries where the government intervenes in the credit allocation These banks are either directly government owned or operated, or they are indirectly government controlled Banking regulation by those countries might function to force banks to give loans to targeted borrowers By bailing out banks, policymakers intend to retain their power of directing credit rather than admit that banks go bankrupt because of the bad loans they were forced to originate 4

3 Competition between legislators: Since not all banks within a country serve the same regions or markets, a variety of legislators might protect their re-maintenance These guardians may want to ensure that banks in their sphere of influence receive the same benefits as other banks, which automatically results in competition for TBTF support 5 Furthermore, legislators could feel more responsible towards their own constit- uency, e.g., by saving jobs locally by a bailout and by neglecting the overall public.

4 Short-term votes: Under this perspective of the political economy, policymakers are primarily oriented towards gaining popularity among voters in order to get (re-) elected 6 This means, they are aligned with the taxpayers’ interests, however only on a very short-terms basis Voters can also relate to a variety of bank stakeholders, such as depositors, borrowers, or employees.

5 Save deposit insurance funds: This is the crucial case when deposit insurance and bailout authority are united in the same hands of policymaker The incentives might contradict each other, and a policymaker could encourage a bailout to avoid having to

4.1 Explicit Government Guarantees (EGGs) (Bailout)

66 4 TBTF Causal Chain: Explicit and Implicit Government Guarantees justify an outflow of deposit insurance funds or when the statutory deposit guarantee scheme is insufficient to protect depositors 7

6 Personal welfare: The policymaker might act to his own benefit, i.e., like a free agent 8 He might advance his career to maximise his personal gain 9 or react to public pressure he is unable to resist This is truer for policymakers than career regulators, who are more independent and do not need to be re-elected 10 The public has a limited ability to assess the decisions of legislators and may judge externally visible outcomes Thus, an absence of crisis or bank failure might be interpreted as a positive outcome and offers personal and bureaucratic rewards 11 Furthermore, the “quiet-life” or hubris hypothesis may motivate the behaviour of avoiding potential litigation from bondholders in case of a bail-in instead of a bailout 12

Subsequently, for the sake of simplified reasoning, it is assumed that the policymaker’s sole objective is to safeguard economic stability.

Bank bailouts lack fixed criteria, as governments prioritize economic stability and the continuity of banking operations In a market economy, long-term nationalization is not the goal; thus, governments strive to prevent banks from becoming entirely reliant on direct funding Ensuring banks maintain access to diverse funding sources is essential for their operations, including lending to the real economy This access hinges on the trust of the bank's creditors, who must believe there will be no credit or liquidity losses The government fosters this trust by guaranteeing the prompt repayment of a bank's uninsured liabilities through specific bailout measures.

7 Most notable is the case of the FDIC, which during some period was responsible for both deposit insurance and deciding on public bailouts (see Sect 3.4.2).

12 The use of opportunistic forbearance methods (see Sect 4.1.3) for the bailout is connected with this motivation.

13 Credit loss is defined as the legally entitled share of the insolvent bank’s realised recovery value minus the repayment value under no bank distress (i.e., the value at par) (Kaufman (2014, 216)).

Liquidity loss refers to the postponement in receiving proceeds from realized recovery amounts, which may occur due to efforts to prevent significant fire-sale losses or due to legal restrictions on withdrawals for a specified duration (Kaufman, 2014, 216–17).

Policymakers face discretionary decisions on which classes of liabilities, such as deposits and debt issuances, to protect during bank bailouts, influenced by the anticipated economic damage from potential losses borne by these holders Historically, these decisions have lacked rigorous quantification of public costs and benefits, often relying on broad generalizations rather than precise assessments.

The scope of protection under the Too Big to Fail (TBTF) policy is illustrated in Table 4.1, which categorizes a bank's liabilities from insured deposits to shareholdings based on their legal liquidation priority This hierarchy indicates that creditors are entitled to the bank's assets according to their position, meaning short-term debt holders receive payouts only after long-term depositors have been compensated.

In practice, the allocation mechanism in a bailout may not follow a strict order There exists a fluid transition between a bank's debt and equity instruments, with hybrid instruments often blurring the lines between the two categories The concept of "Too Big to Fail" (TBTF) is influenced by the level of protection afforded to various liabilities, which is quantified on a scale from 0 to 13, where the dots indicate the degree of protection for each respective liability.

Implicit Government Guarantees (IGGs)

An IGG provides deposit insurance for uninsured bank liabilities without requiring premium payments from the insured G-SIB, amplifying the fundamental effects of deposit insurance The mechanisms through which banks obtain IGGs and transfer potential loss liabilities to the state are explored in detail This selective government intervention in a free-market economy inevitably distorts market forces and creates moral hazards The behavior of various bank stakeholders, including creditors, management, and shareholders, is analyzed to understand the broader implications of these changes, supported by empirical evidence where applicable.

An IGG has two possible origins:

1 An official government statement designates a bank TBTF for two possible reasons: a to pre-emptively give certainty to bank stakeholders and other market participants, and to stabilise the overall banking system, or b to impose special regulatory requirements on the bank.

2 The market perceives a bank to be TBTF This, in contrast, is based on the expecta- tion of potential public bailout measures The market participants that would potentially benefit from an EGG know what motivates policymakers to opt for a bailout (Sect 4.1.1) Hence, even if a bank is not officially designated as TBTF, market participants will treat a bank as such if they are aware of the systemic importance and react to it by reasonably anticipating the EGG 40

While a bank may be officially labeled as "Too Big to Fail" (TBTF), the specifics of any future bailout are often not clearly outlined in advance The effectiveness of the implicit government guarantee (IGG) and its associated moral hazard largely hinges on market expectations regarding the likelihood and extent of emergency government guarantees (EGGs) These expectations are typically shaped by historical instances of public intervention and previous bailout scenarios.

The value of an IGG (Implicit Government Guarantee) for banks and their counterparties hinges not only on the anticipated strength of a bailout but also on the overall condition of the financial system During periods of market uncertainty or volatility, such as a banking crisis, the value of this potential protection increases significantly, functioning similarly to a put option that approaches the money.

It is worthwhile to note several factors that mitigate the strength and value of IGGs:

1 TBTF regulation: TBTF regulations constitute additional regulation and supervision of G-SIBs These may include legislation concerning the contractual liability write- offs during a bailout—a so-called bail-in (see Sect 6.3) 43

Some countries lack the public finance capacity needed to effectively safeguard Global Systemically Important Banks (G-SIBs), leading to the term ‘too-big-to-save.’ This situation suggests that the failure of these banks could result in national insolvency, highlighting the risks associated with their size and significance in the financial system.

3 ‘Too-many-to-fail’: This term names a general weakness of an entire banking sector that implies that a government is less likely to protect one bank because

41 In a comprehensive study of the international banks of 104 countries over the period of 1989–

2007, Cubillas, Fernández, and González (2016) find that IGGs are stronger in countries that did not impose losses on depositors in previous banking crises.

Research by Schich and Lindh (2012) indicates that the strength of the IGG experienced an increase at the onset of the 2007–2009 financial crisis, but has since diminished over time.

44 See Demirgỹỗ-Kunt and Huizinga (2013), Schich and Lindh (2012), and Cubillas, Fernỏndez, and González (2016) Recent examples are Iceland in 2008, Ireland in 2010, and Cyprus in 2013.

74 4 TBTF Causal Chain: Explicit and Implicit Government Guarantees it cannot protect all similarly weak G-SIBs 45 This scenario is also known as a

Due to the above-named complexities, the extent of IGGs differs across countries and across banks within one country 47

Creditor moral hazard arises when all liability holders, beyond just depositors protected by statutory deposit insurance, anticipate being safeguarded by a bailout of a Global Systemically Important Bank (G-SIB) This phenomenon results in reduced funding costs and increased counterparty positions for G-SIBs, as creditors exhibit lower return requirements due to the perceived safety of their investments.

The presence of an insolvency guarantee mechanism (IGG) significantly reduces the default probability of bank liabilities, as creditors are repaid from the insolvency estate in the event of bankruptcy This mechanism acts as a safety net, leading to a decreased likelihood of default for various liabilities, including derivative contracts Consequently, bank creditors benefit from lower lending rates due to the improved risk/return dynamics, while counterparties are inclined to take on larger positions and factor in reduced counterparty risk The literature identifies two primary approaches that underpin this concept of lower default probability.

– An ‘objective argument’, mostly measured by market CDS spreads, and

– A ‘subjective argument’, measured by credit rating differences.

• Lower bank monitoring costs: The IGG partly replaces the necessity of monitoring the counterparty bank, which results in a decrease in associated costs.

Economic costs, or negative public economies, arise when investors perceive a bank as "too big to fail" (TBTF) These costs reflect the savings in total expenditures for the bank and its creditors due to the TBTF designation, including reduced funding and monitoring costs Empirical studies have examined these theoretical claims, particularly focusing on the decreased probability of default as indicated by credit ratings and CDS spreads However, the empirical analysis of lower monitoring costs and larger counterparty positions remains limited Additionally, the extent to which creditors versus banks benefit from creditor moral hazard is still uncertain.

Research consistently shows that Global Systemically Important Banks (G-SIBs) enjoy substantial funding cost advantages due to Implicit Government Guarantees (IGGs) This finding is evident across various methodologies employed in the studies, underscoring the dominance of G-SIBs in this area of financial analysis.

Credit rating agencies assess the creditworthiness of banks by publishing various ratings that indicate the likelihood of default based on their own criteria While these ratings are subjective and may not always be accurate, they significantly influence market perceptions of a bank's solvency, affecting investment and pricing decisions by debt holders Higher credit ratings typically lead to more favorable funding conditions, as they serve as benchmarks for central banks and wholesale operations, establishing minimum collateral requirements Consequently, improved ratings not only enhance a bank's reputation but also facilitate better funding opportunities.

The three leading credit-rating agencies—Standard & Poor’s (S&P), Moody’s, and Fitch—provide two key issuer ratings essential for evaluating banks: the stand-alone issuer rating, which assesses a bank's inherent ability to meet its obligations, and the overall issuer rating, which considers the bank's repayment capacity with potential external support.

Several studies have measured the "Too Big to Fail" (TBTF) effect by comparing credit ratings of banks, revealing that institutions deemed TBTF benefit from significant rating uplifts, or upgrades, due to perceived external support, mainly from the government This rating advantage, which can range from one to four notches, tends to be more pronounced following government interventions Additionally, factors such as a bank's lower stand-alone rating, larger domestic market share, and the greater solvency of the bank's sovereign contribute to higher implicit government guarantees (IGGs).

Over the years, various terms have been used to describe bank ratings, including 'Standard & Poor’s Underlying Rating' (SPUR), Moody’s 'Bank Financial Strength Rating' (BFSR) and 'Baseline Credit Assessments' (BCA), as well as Fitch’s 'Bank Individual Rating' and 'Viability Rating' (VR).

Economies of Large Banks (Incentives for Scale and Scope)

This section prepares for the analysis of public costs and benefits associated with IGGs, highlighting a significant trade-off in G-SIBs related to economic efficiency, systemic importance, and economies of scale and scope These factors are influenced by various criteria, with a bank's size being a key measure, as larger institutions account for a substantial portion of banking output Typically, size is quantified by the total assets held by a bank.

Intuitive questions arise in this context: First, what is the socially optimal bank size?

Banks can achieve economies of scale and scope up to a certain size, which represents the optimal growth limit that enhances public welfare It is essential to explore whether there are super-scale economies that provide efficiency gains for Global Systemically Important Banks (G-SIBs) or if inefficiencies arise beyond this socially optimal size These insights are vital for conducting a cost-benefit analysis regarding the public value of banks deemed "Too Big To Fail" (TBTF), especially after accounting for the public subsidies associated with their size Additionally, understanding these dynamics is crucial for informing regulatory policies that may impose limits on bank sizes.

In a competitive banking environment, economic efficiency relies on the interplay of competition, regulation, and firm economies, each presenting its own trade-offs This discussion emphasizes the importance of firm economies, specifically exploring how banks can enhance their operational efficiency.

The economic efficiency of firms can be divided into two key components: technical efficiency, which focuses on delivering bank services at the lowest possible cost, and allocative efficiency, which ensures the optimal distribution and allocation of these services within society Together, these efficiencies represent the ability to produce bank services in the most effective manner and in the right quantities.

The efficiency function of a bank can exhibit a U-shape, indicating that a bank's sub-optimal size may lead to inefficient choices in both input and output quantities.

Large banks that face limited competition may foster X-inefficiency and diseconomies To determine the socially optimal size of a bank, it is essential to focus on studies that exclude external factors, such as the Too Big to Fail (TBTF) doctrine, from their analyses.

Table 5.1 outlines various methods banks can enhance their efficiency, as identified in existing literature While X-efficiency stands out, the other sources suggest growth in scale, scope, or other dimensions Efficiency improvements benefit the public, shareholders, and managers by lowering costs, increasing revenues, and mitigating risks, ultimately enhancing value at existing price levels However, conflicts of interest among bank stakeholders can lead to misaligned incentives, resulting in banks profiting at the expense of others Consequently, efficiency sources are categorized into (i) economies of scale, (ii) economies of scope, (iii) X-efficiency that enhances public welfare, and (iv) economies that exploit public welfare The extensive literature on bank mergers and acquisitions primarily focuses on cost efficiencies within U.S banks, emphasizing organic scale while giving less attention to scope due to empirical challenges.

5 Cf Qayyum, Khan, and Ghani (2006, 733–34) and Dermine (2014, 103–4).

Published studies on bank economies often share common caveats due to the complexity of the analysis, making comparisons between research results problematic A significant challenge in statistics is accurately considering and measuring all relevant factors, including the Too Big To Fail (TBTF) doctrine However, advancements in statistical techniques have enhanced the ability to account for extreme variations in data samples The primary challenges stem from the underlying data utilized in these studies.

Bank-internal factors significantly influence banking operations, with bank size being notably skewed (DeYoung, 2010) The variety of banking services offered complicates analysis due to limited data on specific products, often leading to reliance on bank-wide data (Dermine, 2014) Different banking services, such as standardized custody services versus complex M&A advisory, yield distinct economies Additionally, small and large banks typically operate in different sectors and generate revenue through varied methods (DeYoung, 2010) Furthermore, varying levels of risk-taking among banks introduce complexity, as larger banks may pursue greater risk due to better diversification, which can skew econometric results when perceived as a cost (Hughes and Mester, 2013).

Environmental factors, particularly a country's characteristics, significantly influence a bank's potential for geographic and product expansion Public policy shapes these dynamics, impacting the regulatory costs that banks must navigate Additionally, large banks benefit from economies of scale and scope, which provide them with incentives to grow and diversify their operations effectively.

86 5 Public Costs and Benefits of TBTF

Table 5.1 Summary of Scale and Scope Economies of Banks

Economies of scale in banking refer to the marginal production efficiencies gained through increased bank size, leading to cost savings, enhanced brand recognition, and revenue growth Generally, these scale effects account for less than 5 percent of costs, while revenues increase modestly by 1 to 4 percent, particularly in smaller banks or those engaged in capital market activities However, there is a lack of consensus on the existence of economies of scale in banking, possibly due to statistical complexities and the evolving nature of banking characteristics Advances in information and communication technologies have significantly impacted the sector, benefiting larger banks that can distribute rising fixed technology costs across a larger customer base Consequently, economies of scale have steadily increased over the years, with the ideal bank size also expanding Recent technological advancements have transformed the banking landscape, leading to debates about the reliability of scale economy estimates for very large banks in the current environment.

Research indicates a consensus on the inefficiency of very small banks, defined as those with assets under a few hundred million US dollars Older studies have focused on this sector, highlighting that these institutions often operate below the minimum efficient scale.

10 Cost-based economies of scale are measured with respect to costs and refer to how size is related to costs (Mester (2010, 10–11)).

15 For a literature review of scale economies in international and US banking see Berger and Humphrey (1997, 175) and Mester (2010), respectively.

5.1 Economies of Large Banks (Incentives for Scale and Scope) as consumer protection (Mester (2010) and Wheelock and Lopez (2012, 11)) (ii) Information and communication technology advancements: Bank operations depend increasingly and to a large extent on information and communication technology This field has seen significant technical advancements in recent decades Consequently, other factors, such as the proximity to clients and personal client relationships, are increasingly less important.

Recent studies on large universal and commercial banks, particularly in the US and European banking sectors, reveal consistent findings regarding scale and scope economies and efficiencies (Berger and Humphrey, 1994) These studies indicate that smaller financial systems generally exhibit lower economies of scale (Beccalli, Anolli, and Borello, 2015).

88 5 Public Costs and Benefits of TBTF increased rapidly from the beginning of the millennium from US$ 0.5 billion to US$ 25 billion today—an amount that may still be rising 17

Recent studies focus on larger banks and the concept of super-scale economies, concluding that banks with total assets up to US$100 billion can achieve economies of scale However, evidence becomes mixed for banks exceeding this threshold, with findings varying based on factors like market power and risk diversification Even when accounting for "too big to fail" (TBTF) elements, evidence for and against scale economies in very large international banks persists Advocates for super-scale economies suggest they are present in banks that prioritize investment banking to cater to large, global non-financial enterprises.

Public Costs and Benefits of EGGs

Costs of EGGs (Bailout Costs)

The costs of EGGs are primarily viewed through a narrow fiscal lens, focusing on the transfer of wealth from the public to Global Systemically Important Banks (G-SIBs) during bailouts These costs include direct cash flows related to various bailout methods and administrative expenses, typically equating to the subsequent rise in the value of the banks' debt or equity Additionally, there are indirect opportunity costs, as bailout funds may be diverted from other uses, necessitating government borrowing, tax increases, or money printing Such increases in debt relative to GDP can adversely affect a country's sovereign debt rating, while expansionary monetary policies may lead to inflation and currency depreciation The ultimate financial impact on the public from EGGs remains uncertain; government investments in G-SIBs or their distressed assets could yield profits post-crisis, and due to the visibility of EGGs, G-SIBs may be compelled to repay some or all bailout costs.

Research indicates that extensive rescue measures, including blanket guarantees, unlimited liquidity support, and ongoing recapitalizations, can result in budgetary expenditures that surpass a nation's GDP and potentially lead to public bankruptcy During the Global Financial Crisis, the average direct costs for Eurozone countries were significant.

Research by Anginer, Demirgüç-Kunt, and Zhu (2014) indicates a strong negative correlation between bank competition and systemic risk, suggesting that increased competition leads banks to adopt more diversified risks, thereby enhancing the resilience of the banking system against economic shocks.

5.2 Public Costs and Benefits of EGGs

The public costs and benefits of "Too Big to Fail" (TBTF) institutions have significant implications, with estimates indicating that they can account for 46 to 47 percent of a country's GDP This figure starkly contrasts with the 10 percent observed during previous crises, largely due to more rapid direct policy interventions and enhanced expansionary monetary and fiscal support measures.

Benefits of EGGs (Avoidance of Bankruptcy Costs and Economic Output Losses)

A banking crisis can be exacerbated by the failure of a Global Systemically Important Bank (G-SIB), as these institutions play a crucial role in the financial system The primary advantage of an Emergency Government Guarantee (EGG) is to prevent the significant economic costs associated with a G-SIB's bankruptcy However, studying the benefits of G-SIB bailouts is challenging due to the rarity of such failures and the limited availability of data Research typically focuses on the potential output losses—measured as the value of goods and services that would not be produced without a bailout—which can lead to substantial and enduring declines in employment, household wealth, and other economic indicators Additionally, governments may encounter increased fiscal challenges stemming from reduced tax revenues due to lower economic activity and the need for heightened spending to alleviate recession impacts, ultimately resulting in higher public debt.

Modern financial crises significantly impact economies, with costs measured as deviations of actual GDP from its trend On average, these costs are substantial and persistent, often exceeding ten percent of pre-crisis GDP, and the median impact stands at around 25 percent.

51 Cf Federal Reserve Bank of Minneapolis (16 November 2016) Laeven and Valencia (2013b,

225) present a comprehensive database on systemic banking crises during 1970–2011 which includes information about costs and policy responses associated with banking crises.

52 Cf Hoggarth, Reis, and Saporta (2002, 851–52), Boyd, Sungkyu, and Smith (2005), and Huertas

53 U.S Government Accountability Office (GAO) (16 January 2013, 17).

54 A G Haldane (30 March 2010) and Reinhart and Rogoff (2011).

Studies estimate that the losses from the Global Financial Crisis (GFC) could range from several trillion dollars to over US$ 14.8 trillion, according to the U.S Government Accountability Office (GAO) and research by Boyd and Heitz.

Direct financial assistance in the UK has exceeded 80% of GDP, while in the US, it has reached nearly 75% of GDP, particularly when including the monetary measures implemented by central banks (Huertas, 2014).

93 a median of 20 percent of GDP in historical crises, partly due to an increase in the size of the financial systems and the initial shocks to the financial system 57

The increasing complexity of financial systems has heightened the severity of financial crises, yet the fiscal impact of Emergency Government Guarantees (EGGs) is mitigated by the regulatory readiness of Globally Systemically Important Banks (G-SIBs) during crises, particularly through effective crisis containment and resolution policies While the costs associated with EGGs are typically short-term, G-SIBs often manage to repay these costs, whereas the long-term benefits of EGGs are substantial, as GDP losses from banking crises tend to be lasting Consequently, from a present value standpoint, the advantages of EGGs generally outweigh their costs, reinforcing the rationale for government bailouts of G-SIBs funded by taxpayers.

Public Costs and Benefits of IGGs

G-SIBs can cause two types of inefficiencies (see Sect 5.1):

TBTF (Too Big to Fail) banks experience diseconomies of scale primarily due to implicit government guarantees (IGGs), leading to significant moral hazards These include creditor moral hazard, bank moral hazard, and shareholder moral hazard, which collectively contribute to the economic inefficiencies associated with TBTF institutions Research indicates that as the size of the IGG increases, so do the indirect social costs and economic inefficiencies, highlighting the broader implications of maintaining large financial institutions.

X-inefficiencies and diseconomies of scale and scope are prevalent among large banks, particularly Global Systemically Important Banks (G-SIBs) Some researchers suggest that G-SIBs struggle with cost efficiency and may be less innovative because they are not compelled to improve by competitive market forces However, there is a lack of empirical evidence to support these claims.

59 Cf Black, Collins, and Robinson (2000, 42).

5.3 Public Costs and Benefits of IGGs

The public costs associated with IGGs are substantial and should be at least equivalent to the benefits derived from EGGs This equivalence is crucial, particularly when considering the potential financial repercussions of a banking crisis that could arise from the Too Big To Fail (TBTF) doctrine.

There is very little evidence of public (efficiency) gains from having G-SIBs 61

Section 5.1 shows that there is no (significant) trade-off between systemic importance and economies of scale (and scope) Systemic importance is believed to start somewhere substantially above US$ 100 million of a bank’s total assets, while economies are believed stop somewhere below this threshold That means that there are no substantial benefits of G-SIBs to be taken into consideration—if any, there might be only operational inefficiencies in addition to the systemic risk inefficiency of G-SIBs Consequently, the social costs of increased systemic risk resulting from IGGs always substantially exceeds any IGG benefits.

Overall Results

Public Costs and Benefits of EGGs and IGGs

Section 5.2 shows that EGG benefits outweigh EGG costs in particular, because potential GDP losses from the absence of G-SIB rescue measures are sustained while bailouts are one-off In other words, EGGs are probably cost effective when executed 62 Section 5.3 shows that massive IGG costs far outweigh nearly non-existent IGG benefits This is intuitive, as there is no public benefit from the existence of G-SIBs, though there is a public imperative for their rescue Both taken together, show that, even under extreme assumptions, the total costs of EGGs and IGGs always exceed the total benefits of EGGs and IGGs 63

The real social costs associated with a Too Big To Fail (TBTF) policy primarily manifest ex ante and indirectly through implicit government guarantees (IGG), resulting in distorted incentives within the financial sector and anticipated crisis costs These issues originate from the IGG, which serves as a breeding ground for external governance gaps (EGG) Consequently, the social costs exceed private costs, as the rational decision-making of individual banks can escalate systemic risk beyond socially optimal levels This highlights the need to address the implications of TBTF policies on overall financial stability.

Market failure occurs when the government must step in with regulations, particularly in the case of institutions deemed "Too Big to Fail" (TBTF) To address this issue, it is essential for the government to require banks to internalize the social costs associated with their TBTF status, as discussed in Chapter 6.

Policymakers' motivations for EGGs are outlined in Section 4.1.1, with public necessity discussed in Section 5.2 In contrast, Section 4.2 highlights the absence of motivations for IGG, while Section 5.3 addresses its lack of public value This raises critical questions about why governments refrain from committing to no future bailouts and why the Too Big To Fail (TBTF) doctrine continues to exist.

The concept of 'time-inconsistency,' often referred to as the 'this-time-is-different syndrome,' presents a significant challenge in banking regulation Policymakers tend to focus on the immediate benefits of government guarantees, particularly in the short term, which are easier to assess and generally yield positive outcomes However, the long-term social costs associated with implicit government guarantees (IGGs) are often overlooked This economic dilemma exacerbates the issues surrounding the "Too Big To Fail" (TBTF) doctrine, as government commitments are likely to falter when faced with rational economic actors who base their decisions on expectations rather than rigid constraints.

Time-inconsistency in political economy highlights the short-term focus of politicians who prioritize winning votes over long-term commitments Voters, as well as bank stakeholders like depositors, borrowers, and employees, often benefit from immediate gains Additionally, the frequency of legislative periods often surpasses the occurrence of banking crises caused by Global Systemically Important Banks (G-SIBs) As a result, politicians may disregard long-term promises made by previous governments, especially if a bailout yields short-term positive outcomes within their tenure This inherent time-inconsistency undermines the credibility of government pledges for rational bank stakeholders.

67 See Kydland and Prescott (1977, 473) and Calvo (1978, 1411).

70 Cf how discretion of the FDIC has undermined the effectiveness of strict policies for bailouts (see Sect 3.4.3).

Some authors suggest that appointing a 'conservative' regulator can help address the time-inconsistency problem by ensuring long-term, independent oversight, separate from the ruling government However, this separation raises concerns, as elected officials ultimately govern the system in a democracy Historical evidence indicates that during crises, governments often override regulatory bodies, especially to avert bank failures.

73 Brock (2000, 69) confirms this practise by analysing Chile’s banking history.

The debate surrounding time-inconsistency in banking crises highlights the choice between discretionary policies and rigid rules for managing systemic risk Banking crises are often unpredictable, suggesting that flexible, discretionary approaches may be more effective in crisis response Freixas (1999) advocates for a strategy of "creative ambiguity" among regulators, tailored to the social costs associated with bank failures However, the reliance on discretionary policies can exacerbate the time-inconsistency issue, resulting in a series of suboptimal policy decisions (Mishkin, 2006).

The GFC and the Policy Responses

The Global Financial Crisis (GFC) marked the most significant wave of banking crises since the Great Depression, primarily impacting advanced economies with Global Systemically Important Banks (G-SIBs) Evidence indicates that the implicit and explicit costs stemming from the "Too Big To Fail" (TBTF) doctrine have been substantial, with G-SIBs playing a pivotal role in these crises The GFC has sparked renewed interest in understanding banking crises and formulating optimal policy responses, revealing that traditional bank regulation is inadequate in light of historical experiences.

Proposals addressing regulatory requirements and fiscal interventions target individual banking crises, while monetary interventions, like standard stabilization measures, are more suited for macroeconomic issues As bank characteristics have evolved and the presence of Global Systemically Important Banks (G-SIBs) has been recognized, both academics and regulators have developed new banking regulations, including specific guidelines for G-SIBs These "Too Big to Fail" (TBTF) policy recommendations aim to mitigate systemic risk and its associated negative externalities, ultimately reducing the likelihood and impact of future banking crises Many of these proposals were initially suggested following earlier crises, such as the Savings and Loan (S&L) crisis.

2 Or existing competition or antitrust law (see Monopolkommission (9 July 2014, 535)).

98 6 TBTF Policy Recommendations crisis, and did not make it into legislation or were subsequently abolished Chapter 7 presents the policy initiatives that have been realised since the GFC.

This chapter outlines key regulatory measures aimed at Global Systemically Important Banks (G-SIBs) and assesses their potential impact It is structured around the three pillars of banking crisis policy: crisis prevention, crisis management, and crisis resolution, providing a comprehensive overview of each aspect.

To address the issues surrounding Global Systemically Important Banks (G-SIBs), a fundamental reevaluation of banking regulations is necessary, potentially including the abolition of deposit insurance, the lender of last resort (LOLR), limited shareholder liability, and the tax deduction of debt However, such comprehensive changes are infrequently proposed, with regulators often opting for restrictions on size and scope instead This situation reflects the "financial trilemma," where regulators must balance three objectives—financial stability, financial integration, and national financial policies—yet can only achieve two simultaneously.

Current proposals aim to reduce the likelihood of banking crises caused by Global Systemically Important Banks (G-SIBs) by requiring these institutions to internalize some of the social costs associated with their operations, effectively penalizing those that have become too systemically important The primary focus of research is on crisis prevention, although crisis management and resolution measures also play a role by providing essential signaling It is important to note that comparing various regulatory proposals is complex, and there is a lack of consensus on the appropriate regulatory approach, as evidenced by differing regulatory targets among stakeholders.

According to Musgrave and Musgrave (1989), public policies serve three primary functions: allocation, stabilization, and distribution Notably, systemic risk plays a crucial role in allocation policies, particularly in the context of crisis-prevention regulation for public goods (De Bandt and Hartmann 2000, 16).

Five comprehensive proposals have been developed, featuring a range of measures in response to government requests Key reports include the Turner Review by the Financial Services Authority (FSA) from March 2009, the Liikanen Report published on October 2, 2012, the Vickers Report from the Independent Commission on Banking in September 2011, and the Edmonds Report.

Crisis Prevention (ex ante)

policies aim to reduce the fiscal costs of banking crisis while others aim to reduce the economic costs of lost output 10

Measures designed to prevent a crisis focus on minimizing the systemic risk posed by Global Systemically Important Banks (G-SIBs) by addressing their contribution and sensitivity to systemic risk Recommendations emphasize the significance of banking market participants rather than the transmission of risk, as interconnections in the financial market are not inherently detrimental Similar to pollution issues in economics, both market-based and government-based solutions are available to tackle these challenges.

Market-Based Solutions (Market Discipline)

Strengthening market discipline serves as the primary defense against "Too Big to Fail" (TBTF) institutions, as it enhances the intrinsic motivation of bank stakeholders to effectively manage and control their banks This leads to safer, sounder, and more efficient business operations Market discipline creates strong incentives, reducing the likelihood of regulatory issues such as regulatory arbitrage To bolster market-based crisis prevention, two complementary strategies should be considered.

Effective corporate governance enhances market discipline by addressing information asymmetries and price distortions that contribute to moral hazard issues Key strategies include improving corporate governance practices, increasing public disclosure, and implementing risk-based pricing for deposit insurance Additionally, deregulatory measures can play a role in fostering better market discipline, which indirectly encourages banks to uphold stronger capital, funding, and liquidity positions.

• Supervision (see Sect 6.1.2): Enhanced supervision by third parties—i.e., financial regulatory bodies—complements and promotes the intrinsic monitoring of traditional bank stakeholders by a adding a further, particularly knowledgeable control.

10 Laeven and Valencia (2013a, 233) The main difficulties of banking regulation are summarised in Sect 2.7.

12 Cf Barth, Caprio, and Levine (2004, 205) and Basel Committee on Banking Supervision (BCBS) (June 1999, 17–18).

While market-based solutions could play a role, government intervention is essential for banks to fully address the externalities associated with "Too Big to Fail" (TBTF) institutions Following the economic theory of pollution, the government can either manage these activities directly, similar to its roles in policing and defense, or delegate them to private banks, ensuring regulation through various means.

Restrictions, often referred to as command and control regulations, impose direct limits on bank activities, including constraints on the size and scope of assets and operations These regulations provide social benefits, particularly in complex systems where risk assessment is challenging, and they can remain effective even if other regulatory components fail However, strict limits may hinder banks' ability to achieve scale and scope economies, potentially leading to increased costs and other negative externalities Additionally, such restrictions may incentivize risk-taking to shift towards the unregulated shadow banking market, failing to mitigate systemic risk.

Price-based regulations, also known as Pigouvian taxation, aim to deter certain banking practices by imposing external diseconomies that compel banks to internalize externalities These regulations often apply stricter measures to a select group of banks, such as Global Systemically Important Banks (G-SIBs), including surcharges on liquidity and capital requirements for unforeseen events, which enhance market discipline This approach aligns the interests of banks and regulators, fostering efficient incentives while leveraging market forces G-SIBs are encouraged to internalize the social costs associated with being "too big to fail" (TBTF) by self-regulating their production levels However, a notable drawback is the challenge of internalizing the tail risk associated with TBTF, as no capital buffer may be sufficient to prevent the potential failure of a G-SIB due to the inherently risk-seeking behavior in banking.

14 A G Haldane (30 March 2010) calls these the advantages of modularity and robustness of prohibition.

Cap-and-trade regulations exemplify the Coasean approach, where the government assigns property rights to banks, allowing them to negotiate for the most cost-effective solutions to the "too big to fail" (TBTF) issue This negotiation process helps align private and social costs by pricing the social costs, similar to the trading of CO2 reduction certificates Although the economic outcomes remain consistent regardless of how property rights are initially allocated, individual bank profits will vary Currently, there are no known policy proposals for globally systemically important banks (G-SIBs) utilizing this method, primarily due to significant challenges in practical implementation Disagreements among global governments regarding the implementation of tradable systemic risk certificates and their initial allocation to banks further complicate the situation Additionally, even if a mutually beneficial agreement exists, there is no assurance that banks will successfully negotiate.

Restrictions Versus Price-Based Regulations

Government-based solutions differ significantly from market-based ones, particularly in the context of choosing between quantitative restrictions and price-based regulations The classic public-goods framework proposed by Weitzman (1974) offers a valuable perspective on this issue, suggesting that the optimal level of pollution control is determined by balancing the marginal social benefits of pollution control against the marginal private costs In situations where costs and benefits are known, policymakers may find taxation and restrictions equally viable However, in the case of "Too Big to Fail" (TBTF) institutions, accurately estimating these costs and benefits is challenging, leading to uncertainty Consequently, when uncertainty exists, one regulatory method may provide a more favorable welfare outcome, contingent on the interplay between social benefits and private costs.

When the marginal social benefits lost from an incorrect choice are significant compared to the incurred private costs, implementing quantitative restrictions is optimal This approach allows for effective pollution control with minimal private costs, as prices can fluctuate Conversely, if the private costs associated with the wrong choice are substantial relative to the social benefits that are sacrificed, utilizing taxation to manage these costs is likely to yield a more favorable welfare outcome Essentially, when the marginal social benefit curve is less steep than the marginal private cost curve, taxation becomes the preferred solution, and the opposite holds true in reverse.

Chapter 5 concludes that the main private costs are lost economies of scale and scope These, however, do not exist in banking beyond a moderate threshold That said, the social benefits of avoiding a banking crisis from TBTF and avoiding G-SIB bailouts appear to be high For these reasons, this theoretical perspective on social welfare

102 6 TBTF Policy Recommendations suggests that the imposition of quantitative restrictions to abolish the TBTF problem may be justified.

6.1.1 Corporate Governance (e.g., Compensation and Disclosure)

Strengthened corporate governance enhances market discipline, serving as a natural check against excessive risk-taking and inefficiencies in Globally Systemically Important Banks (G-SIBs) While these measures impact all banks, specific regulations target G-SIBs to mitigate information asymmetries between banks and their investors, thereby improving monitoring Additionally, these measures aim to reduce moral hazards for creditors and banks, reinforcing the fiduciary duty of stakeholders to minimize conflicts of interest.

The Global Financial Crisis (GFC) highlighted significant deficiencies in the information systems of Global Systemically Important Banks (G-SIBs), affecting both public investors and private supervisors The rapid complexity of banking operations has outstripped existing risk-management frameworks, leading to detrimental impacts from financial contagion due to inadequate information disclosure Key gaps include a lack of transparency in sectoral, market, cross-border, and off-balance sheet data, as well as in complex derivatives and over-the-counter products To enhance market participants' ability to evaluate and compare bank exposures, there is a pressing need for a more timely, uniform, transparent, and straightforward presentation of G-SIBs' financial conditions Improved information infrastructures are essential for achieving these objectives.

Corporate governance, often referred to as bank governance, encompasses a wider scope of regulation that includes various measures such as bank capital requirements and resolution regimes, as highlighted by De Bondt (2010) and further discussed by Ellis, Haldane, and Moshirian (2014).

22 Cf ệtker-Robe et al (2011, 15–16).

24 E.g ệtker-Robe et al (2011, 17), De Bondt (2010, 147), French et al (2010b, 17), and Johnston et al (2009, 3).

25 Cf Landier and Thesmar (2014) for the trade-off between the benefits of transparency and the costs of public disclosure of financial data, as increasing transparency may also reduce welfare.

103 be better able to foresee and prevent potential disruptions of the financial systems and to build trust and understanding 27

Reducing Disincentives, Conflicts of Interest and Moral Hazards

Conflicts of interest at Global Systemically Important Banks (G-SIBs) have raised concerns regarding employee compensation, particularly the excessive remuneration of senior managers and traders, which often exploits the imbalance between bank managers and shareholders A significant portion of this compensation, primarily bonuses, is linked to short-term objectives and is disbursed prematurely, lacking accountability To address these issues, it is essential to revise compensation structures, tying payoffs to a bank's survival probability, capital ratios, and risk-adjusted performance targets, thereby aligning stakeholder interests more effectively Implementing bonuses in the form of vested bank shares or subordinated debt over extended periods can enhance this alignment Additionally, G-SIBs should be mandated to retain or claw back a considerable portion of variable remuneration until employee performance uncertainty is significantly mitigated.

In the aftermath of the Global Financial Crisis (GFC), there is growing criticism regarding the increasing complexity of bank products and regulations, particularly with decentralized clearing To mitigate regulatory arbitrage and enhance financial stability, it is essential to simplify regulations and strengthen banks' risk management practices.

Crisis Management (ex post)

Crisis management is activated once a crisis occurs, focusing on short-term government actions aimed at providing liquidity support or capital forbearance It primarily addresses the regulatory framework and the scope of government interventions, as well as the market signals these actions convey In the case of Global Systemically Important Banks (G-SIBs), there is minimal flexibility in crisis management, as these institutions are typically guaranteed rescue during financial turmoil.

The proposal for a policy pledge that permits only the first Global Systemically Important Bank (G-SIB) to fail aims to enhance market discipline among uninsured creditors Advocates argue that the economic repercussions of allowing just one major bank to collapse would surpass the advantages of heightened market discipline This approach is viewed as more credible than a commitment to refrain from bailing out any bank, as it seeks to balance the need for accountability with the potential risks of widespread financial instability.

An international Lender of Last Resort (LOLR) is essential for providing liquidity support to Global Systemically Important Banks (G-SIBs) during crises Given that the interbank market operates globally, the risk of contagion also extends internationally Therefore, advocates assert that establishing an international LOLR is crucial for mitigating the spread of financial instability across borders.

Crisis Resolution

Crisis resolution aims to alleviate the distress faced by Global Systemically Important Banks (G-SIBs), as allowing such institutions to fail and declare bankruptcy is not a viable option for governments The costs associated with a typical bankruptcy resolution, including economic disruption, significantly outweigh the expenses incurred from a G-SIB bailout Therefore, a G-SIB that nears failure, despite existing preventative measures, is deemed inefficient and should not be permitted to re-enter the market in its failed state.

94 Mishkin (2006, 1001) and Stern and Feldman (2009b).

The initial concept for this policy originated before the Global Financial Crisis (GFC), and the collapse of Lehman Brothers played a crucial role in exacerbating the crisis's severity.

The phenomenon of 'zombie' banks, as identified by Kane (1987) during the Savings and Loan (S&L) crisis, arises primarily from regulatory forbearance This regulatory leniency permits insolvent banks to persist in rolling over their debts, as discussed by Kane (2015) and further analyzed by Moyer and Lamy (1992).

There is significant confusion in academic literature regarding the terms "rescue process" (or bailout) and "resolution process" (or restructuring) It is important to note that altering the resolution regime does not impact the rescue process, as highlighted by Kaufman (2015).

In the aftermath of rescuing a Global Systemically Important Bank (G-SIB), the government is urged to implement a strict resolution regime that includes significant restructuring to mitigate moral hazards This regime serves as a preparatory measure for the rare scenario of a G-SIB rescue, functioning as a lighter form of bankruptcy that facilitates the bank's market exit By establishing this framework, policymakers can enhance their credibility and avoid the pitfalls of providing an unlimited safety net Furthermore, improving the government's capacity to uphold essential banking functions makes the resolution process more feasible and credible, ultimately reducing implicit government guarantees This clarity ensures that bank stakeholders, particularly uninsured creditors, are aware of the potential penalties associated with risk-taking, thereby addressing concerns about exposure to losses The proposed resolution regime effectively meets two key government objectives following a G-SIB rescue.

• Living wills and bank resolution—protecting the financial system and vital banking functions

• Burden sharing and individual sanctions—minimising bailout costs and preventing future bailouts and IGG

Living Wills and Bank Resolution

The primary objective in restructuring a rescued Global Systemically Important Bank (G-SIB) is to address the business segments that led to its initial challenges by downsizing operations, creating smaller entities, or liquidating certain parts Simultaneously, it is crucial to maintain the continuity of all essential services provided by the G-SIB to mitigate risks to financial stability The resolution process for a bank is often protracted and intricate, particularly due to the complexities associated with G-SIBs However, various components can facilitate a smoother resolution.

99 E.g., by Squam Lake Working Group on Financial Regulation (2009) and French et al (2010b, 17).

Korte (2015, 213) reveals that a robust implementation of bank resolution rules significantly boosts firm growth, especially for companies that rely heavily on bank financing.

101 Cf Huertas (2014, 82–133) on bank resolutions.

According to Ignatowski and Korte (2015), the implementation of bank-resolution regimes, specifically the orderly liquidation authority in the US, led to a decrease in overall risk-taking, but this effect was observed only among non-G-SIBs (Global Systemically Important Banks) (Mishkin, 2006).

105 Federal Deposit Insurance Corporation (FDIC) & Bank of England (BoE) (10 December 2012, ii).

Banks are required to develop living wills, or bank-resolution plans, to prepare for potential failures, which must be approved by their supervisors These plans allow banks and regulators to thoughtfully consider effective measures to minimize disruptions during a crisis Living wills consist of three key components: first, they identify the complexities of the bank's organizational and financial structures, aiding supervisors in assessing the financial health of Global Systemically Important Banks (G-SIBs) during emergencies Second, they provide a strategic plan for a swift and orderly resolution in distress situations, detailing the legal dismantling process and minimizing reliance on government assistance through recovery capital and liquidity strategies Lastly, living wills establish a framework for facilitating resolution by simplifying legal structures and aligning legal entities with functional business lines While the creation of these living wills and necessary structural changes can be costly, they serve as a significant regulatory measure for G-SIBs.

Establishing living wills presents several challenges, particularly for Global Systemically Important Banks (G-SIBs) that operate across multiple jurisdictions These institutions encounter inconsistencies in resolution plans for cross-border activities, as each national regulator may prioritize retaining more assets within their borders to safeguard local creditors, a phenomenon often referred to as "global asset grab."

To effectively manage the complex resolution of Global Systemically Important Banks (G-SIBs), it is essential to establish a single public institution with comprehensive authority over all resolution aspects, including living will approvals, bailout decisions, and execution of wind-downs This institution should maintain independence from national governments to prioritize global financial stability Additionally, a supranational body is necessary to oversee all G-SIBs, irrespective of their home regulators, to address the challenges posed by cross-border resolutions.

The government must create a comprehensive legislative framework to ensure that Global Systemically Important Banks (G-SIBs) can be resolved efficiently and smoothly An internationally consistent legal regime is essential for rapid resolution processes This framework should incorporate living wills, resolution authorities, and divestiture rules, all aligned with bank recovery provisions and security mechanisms, including institutional security and deposit insurance.

Individual Sanctions and Burden Sharing (bail-in)

Bank rescues are expensive and resolution plans for G-SIBs should minimise these costs Before taxpayers carry the burden of a rescue, bank stakeholders should cover the expenses: 113

Burden sharing with shareholders and creditors is essential in the context of G-SIBs, as legal complications typically prevent the ousting of liability and shareholders unless a bank declares bankruptcy This has historically led to creditors rarely facing losses, as they have not been willing to absorb them To mitigate major financial market disruptions, governments aim to avoid G-SIB bankruptcies, making it crucial for resolution authorities to have the statutory power to restructure the liabilities of distressed G-SIBs This restructuring ensures that shareholders and creditors absorb the losses, providing extra loss-absorbing capacity during crises The bail-in process, which involves writing down unsecured debt or converting it to equity, should align with the legal hierarchy of claims under bankruptcy rather than relying on regulatory discretion, offering debt holders more certainty and preserving the bank's franchise value.

Individual accountability in banking is crucial, as bank management often engages in moral hazard due to short-term incentives Following the Global Financial Crisis (GFC), Global Systemically Important Banks (G-SIBs) faced significant fines for misconduct, yet individual executives were rarely held accountable This discrepancy highlights the need for stronger sanctions on bank management to ensure long-term responsibility and ethical behavior within the financial sector.

113 Sect 4.1.4 lists the ways stakeholders can contribute to bailout costs.

114 Zhou et al (2012, 3) present a comprehensive review of how bail-in works and when it should be applied.

116 Squam Lake Working Group on Financial Regulation (2009).

117 selective basis and for extreme wrong-doings, ethical failures and reckless risk-taking Many reformers call for sanctioning individuals with fines and exclusion from working in banking 118

A stringent resolution regime for nonviable Global Systemically Important Banks (G-SIBs) would enhance market discipline by ensuring that shareholders are eliminated, unsecured creditors bear losses, and management faces penalties This approach would significantly mitigate the moral hazard associated with G-SIBs and decrease the reliance on government funding during financial crises.

European Banking Union

The European banking union has two main pillars:

The Single Supervisory Mechanism (SSM) is an innovative banking supervision system in Europe, integrating the European Central Bank (ECB) with the national supervisory authorities of participating countries All euro area nations automatically take part in the SSM, while other EU countries not yet using the euro have the option to join.

6 Cf Ellis, Haldane, and Moshirian (2014, 175).

4 E.g., the President of the USA, Donald J Trump (Jopson and Leatherby (13 March 2017))

The Single Resolution Mechanism (SRM) aims to enhance the efficiency of resolving failing banks by centralizing decision-making at the EU level It establishes a Single Resolution Board (SRB) to ensure rapid decision-making processes, enabling banks to be resolved within a weekend while requiring creditors to share the financial burden The European Central Bank (ECB) plays a crucial supervisory role in determining a bank's failure status, and a Single Resolution Fund (SRF), funded by bank contributions, will be available to support resolution measures.

The Single Supervisory Mechanism (SSM) is applicable only to large banks with total assets of €30 billion or more, while the Single Resolution Mechanism (SRM) encompasses all banks in participating EU countries Both frameworks were established in 2014 and have since been implemented across the EU They are built upon the foundation of the single rulebook, which standardizes banking supervision laws throughout Europe Key elements of this single rulebook ensure harmonization in the regulation of the banking sector across all EU member states.

1 the Capital Requirements Regulation (CRR) and the Capital Requirements Directive

IV (CRD IV), which are based on the global recommendation of the BCBS (see

2 the Bank Recovery and Resolution Directive (BRRD) and the Deposit Guarantee

3 the regulatory technical standards (RTS) and implementing technical standards (ITS) issued by the European Commission (EC); and

4 the guidelines and recommendations of the European Banking Authority (EBA), which was established on 1 January 2011.

The European banking union has initiated numerous measures, as outlined in Chapter 6, but it is still too early to evaluate their long-term effects, especially concerning potential crises linked to institutions deemed "too big to fail" (TBTF) Nonetheless, the newly established harmonised legal framework reveals opportunities for discretionary government interventions by EU member states A notable instance of this was the significant debt write-off during the financial turmoil at Novo Banco in 2016 and Banco Populare in 2017, signaling a shift where bank bondholders can no longer expect the same level of protection within the EU Additionally, the situation involving Banca Monte dei Paschi di Siena further exemplifies these changes in the banking landscape.

9 Jenkins (April 18, 2016) See also Hale (30 March 2016).

During the same period, the TBTF policy initiatives reveal that a single EU country can effectively influence newly established central institutions to prevent burden-sharing with bank stakeholders, all while utilizing taxpayer funds.

Dodd-Frank Act in the US

The Dodd-Frank Wall Street Reform and Consumer Protection Act, enacted on July 21, 2010, represents the most significant overhaul of financial regulation in the United States since the Great Depression This landmark legislation impacted all federal financial regulatory agencies and the majority of the US financial services industry A primary objective of the Dodd-Frank Act is to eliminate the concept of "too big to fail" (TBTF), as outlined in its preamble Key regulations within the DFA specifically target the TBTF issue, aiming to enhance the stability and accountability of the financial system.

The Financial Stability Act of 2010 established the Financial Stability Oversight Council (FSOC) to identify and address emerging threats to financial stability, particularly from institutions considered too big to fail (TBTF) The Dodd-Frank Act (DFA) classifies systemically important financial institutions (SIFIs) as banks or non-banks with assets exceeding $50 billion, subjecting them to enhanced supervision, higher capital requirements, and additional operational restrictions Furthermore, the Collins Amendment in Section 171 of the DFA mandates a uniform leverage and risk-based capital floor for all U.S banks, which is further supported by the Basel III capital standards.

Title II of the Dodd-Frank Act introduces the Orderly Liquidation Authority (OLA), which enhances the FDIC's power to manage the resolution of failed Systemically Important Financial Institutions (SIFIs) The OLA ensures that the FDIC is reimbursed for any expenses incurred during a SIFI resolution, with funding sourced from all SIFIs This framework offers a more effective alternative to traditional bailouts or bankruptcy Additionally, SIFIs must create resolution plans ahead of time to streamline the bank resolution process.

• Title III—Transfer of Powers to the Comptroller, the FDIC, and the Fed: The

Enhancing Financial Institution Safety and Soundness Act of 2010 ‘is intended to streamline banking regulation and reduce competition and overlaps between different regulators’.

• Title VI—Improvements to Regulation: Section 619 of the Bank and Savings

Association Holding Company and Depository Institution Regulatory Improvements Act of 2010, which is also dubbed Volcker Rule, is particularly relevant It generally

‘prohibits any banking entity from engaging in proprietary trading or from acquiring or retaining an ownership interest in, sponsoring or having certain relationships with a

The separation of hedge funds and private equity funds from traditional banking activities is driven by the need to mitigate conflicts of interest and excessive risk-taking When banks engage in lending, securities underwriting, and market-making alongside proprietary trading and personal investments, the potential for conflicts increases significantly This institutional separation aims to enhance financial stability and protect investors.

In summary, the significant reforms brought about by the DFA makes the US significantly better prepared, on paper, against systemic risks due to TBTF Although the DFA

The article discusses the Office of Financial Stability's (OLA) approach to managing large financial firms in distress, presenting unassisted bankruptcy as the preferred option It highlights that regulators have the authority to intervene through an administrative process if unassisted failure poses a threat to financial stability Although initial funding may come from taxpayer money, the Dodd-Frank Act mandates that Systemically Important Financial Institutions (SIFIs) subsequently finance the OLA However, the overall impact of the OLA is likely to perpetuate the moral hazard issue in the financial sector.

Global BCBS regulation: Basel III

The Basel III regulatory framework, developed by the Basel Committee on Banking Supervision (BCBS), was published on December 16, 2010, and finalized on December 7, 2017, following extensive revisions prompted by the Global Financial Crisis (GFC) This framework aims to establish a more disciplined and less procyclical financial system that fosters sustainable economic growth The BCBS's policies serve as recommendations for minimum standards to enhance the regulation, supervision, and risk management of the banking sector, which must be implemented into law by participating countries Comprising 45 members from 28 major developed nations, including central banks and banking regulators, the BCBS's influence extends globally, impacting financial systems worldwide.

Basel III essentially targets the two fundamental bank risks: credit risk (to be contained by capital regulations) and liquidity risk (to be contained by liquidity regulations) (see Fig 7.1) Completely new are the rules on liquidity, which are in place due to the lessons learnt from the GFC when various bank funding markets dried up completely.

10 Chow and Surti (2011, 13) This is similar to the Glass–Steagall Act of 1933 (see Sect 3.4.2).

13 Basel Committee on Banking Supervision (BCBS) (December 2017).

Basel III builds upon Basel II and incorporates decisions made by the Basel Committee on Banking Supervision (BCBS) since then Notably, it includes a set of enhancements known as “Basel II plus” or “Basel 2.5,” implemented between 2009 and 2011, aimed at reinforcing regulations, particularly concerning securitisations and market risk.

Basel III capital regulation aims to prevent excessive leverage similar to that seen during the Global Financial Crisis (GFC) by tightening the three pillars established in Basel II Pillar 1 mandates that banks maintain minimum capital ratios, while Pillar 2 involves the Internal Capital Adequacy Assessment Process (ICAAP) and the Supervisory Review and Evaluation Process (SREP), which allow both bank management and regulators to evaluate a bank's capital adequacy This assessment can result in discretionary capital surcharges beyond those required in Pillar 1 Additionally, Pillar 3 enhances market discipline by requiring public disclosure of information, enabling external stakeholders to assess banks' capital positions effectively.

The restructured Basel regulation centers around Pillar 1's minimum capital ratio, which guarantees that banks maintain adequate capitalization to withstand unforeseen risks This primary capital ratio is crucial for financial stability.

This equation contains the following elements:

Common equity tier 1 (CET1) capital is a crucial component of banking regulations, particularly under Basel III, which emphasizes the importance of genuine equity for absorbing losses Unlike Basel I and II, which considered total capital—including capital securities like subordinated debt—Basel III narrows the focus to common equity alone This shift highlights the lessons learned from the Global Financial Crisis, reinforcing the need for stronger capital standards to ensure financial stability.

Fig 7.1 Components of Basel I-III

Risk-weighted assets (RWA) are calculated by multiplying bank assets with specific risk factors to account for varying expected losses, as mandated by Basel I Banks can choose between a standardized approach with fixed risk buckets or two internal ratings-based approaches (IRBA) that require their own risk estimations Credit risk is typically the primary contributor to RWA, although trading and operational risks are also included in the calculation Basel III has tightened the calculation methods for these risk types and established a minimum output floor of 72.5% for the total RWA amount.

Under Basel III, the focus has shifted to Common Equity Tier 1 (CET1) capital, with minimum ratios significantly increased from the previous Basel I and II requirements of eight percent total capital of risk-weighted assets (RWA) By 2019, institutions must fully comply with these enhanced requirements, which include a fixed capital conservation buffer of 2.5 percent and a countercyclical buffer of up to 2.5 percent, activated when authorities identify excessive credit growth posing systemic risks Additionally, Global Systemically Important Banks (G-SIBs) are mandated to maintain an extra CET1 capital of up to 3.5 percent.

15 Under IRBA the expected losses of assets are generally calculated as: Expected Loss (EL) =

Loss Given Default (LGD) × Probability of Default (PD) × Exposure at Default (EaD).

7.3 Global BCBS regulation: Basel III

Basel III introduces a leverage ratio to prevent excessive bank leverage, particularly when risk-weightings are low, such as in large government bond portfolios This ratio offers a simpler alternative to capital ratios, reducing the potential for gaming behavior The minimum leverage ratio is set at 3.0 percent and has been in effect since 2018.

Basel III implements two ratios with regard to the liquidity risk of banks: the liquidity coverage ratio (LCR), which covers a short-term, 30-day stress scenario; and the net stable funding ratio (NSFR), which is designed to ensure that banks will be funded in a 12-months crisis scenario.

Global FSB Regulation: G-SIBs

The G20 meeting in November 2008 occurred during the Global Financial Crisis (GFC), where member nations emphasized the need for enhanced prudential regulation of Global Systemically Important Banks (G-SIBs) This collective call for regulatory reform resulted in the creation of the Financial Stability Board (FSB) in April 2009, aimed at promoting international financial stability.

The Financial Stability Board (FSB) enhances cooperation among national and international supervisory bodies to promote global financial stability, following the framework set by the Financial Stability Forum (FSF) After the Basel III agreement in 2010, which impacts banks of all sizes, G20 leaders shifted their focus to institutions considered too big to fail (TBTF), now referred to as global-systemically important financial institutions (G-SIFIs) The FSB's G-SIB regulation, closely linked to Basel III, emphasizes capital requirements for these targeted banks In autumn 2011, the FSB and Basel Committee on Banking Supervision (BCBS) endorsed additional capital surcharges and published the first official list of 29 designated G-SIBs.

Table 7.1 Basel III minimum capital requirements

16 Based on Moenninghoff, Ongena, and Wieandt (2015, 226) and updated for events until the end of 2015.

Table 7.2 Overview of FSB Event Dates (2008–2015)

Source: Moenninghoff, Ongena, and Wieandt (2015, 226), Financial Stability Board (FSB)

(1 November 2012, 226), Financial Stability Board (FSB) (11 November 2013, 226), Financial Stability Board (FSB) (6 November 2014, 226), Financial Stability Board (FSB) (10 November

2014, 226), Financial Stability Board (FSB) (3 November 2015, 226), and Financial Stability Board (FSB) (9 November 2015, 226).

In November 2012, the G20 committed to implementing the BCBS recommendations regarding the prudential treatment of domestic-systemically important banks (D-SIBs) and other-systemically important institutions (O-SIIs) On April 25, 2016, the EBA released the first list of D-SIBs in the EU, identifying 17 banks that must maintain additional CET1 capital of up to 2.0 percent, following a phase-in period that concluded in 2019 This discussion primarily focuses on global systemically important banks (G-SIBs).

The Basel Committee on Banking Supervision (BCBS) has established an indicator-based measurement approach to identify Global Systemically Important Banks (G-SIBs) This method utilizes a scoring system that incorporates twelve indicators distributed across five equally weighted categories: cross-jurisdictional activity, size, interconnectedness, substitutability, and complexity These categories align with widely recognized factors contributing to systemic risk, with each indicator being scored on a scale from zero.

The assessment of global banks involves calculating each bank's reported value as a percentage of the total value from a panel of 75 major institutions, focusing primarily on size and Basel III leverage ratio exposure This selection process also incorporates supervisory discretion, with banks evaluated solely on a consolidated basis The resulting indicators are aggregated into an overall score, and the analysis, along with the designation of Global Systemically Important Banks (G-SIB), is conducted annually.

Table 7.3 BCBS Indicator-Based Measurement Approach for Assessing G-SIBs

Source: Basel Committee on Banking Supervision (BCBS) (July 2013, 6).

17 European Banking Authority (EBA) (25 April 2016).

18 See Basel Committee on Banking Supervision (BCBS) (July 2013, 6) for the latest comprehensive assessment methodology.

The Basel Committee on Banking Supervision (BCBS) published a score calculation methodology in November 2014, which was further refined by Loudis and Allahrakha in 2016, providing a comprehensive list of scores for each bank and category.

The Financial Stability Board (FSB) establishes the threshold for Global Systemically Important Banks (G-SIBs) based on an overall score Since the official G-SIB list was first published in 2011, approximately 30 banks have been designated as G-SIBs annually Table 7.4 includes the G-SIB lists for 2009 and 2010, derived from a leaked preliminary list published by The Financial Times The composition of the G-SIB list reflects the ongoing assessment of banks' systemic importance in the global financial system.

The timeline of significant reports by Jenkins and Davies, along with the Financial Stability Board (FSB), highlights critical developments in financial stability from November 2009 to November 2016 These documents reflect ongoing efforts to address financial system vulnerabilities and enhance regulatory frameworks, emphasizing the importance of robust financial oversight in maintaining global economic stability.

From 2011 to 2015, the TBTF policy initiatives saw only minor changes, with five banks adapting after the first year of implementation Approximately half of the Global Systemically Important Banks (G-SIBs) are based in the EU, one third in the US, and the rest in Japan and China These major banks dominate all twelve key financial indicators, holding a substantial portion of the global financial system Specifically, G-SIBs represent around 40% of total Tier 1 capital and assets, over 65% of total assets under custody, more than 90% of foreign exchange trading, and over 70% of loan syndication, bond underwriting, and equity underwriting volumes Additionally, G-SIBs are typically the top players in their domestic retail markets and play crucial roles in financial market infrastructures, including payment systems, trade settlement systems, and central counterparties.

The FSB capital regulation has two components:

The CET1 capital surcharge, a key measure under Basel III, ranges from 1.0% to 3.5%, with the current maximum set at 2.5% This surcharge is determined by the risk bucket assigned to Global Systemically Important Banks (G-SIBs), which reflects their systemic relevance The implementation of these requirements was phased in from January 1, 2016, to January 1, 2019.

Total Loss-Absorbing Capacity (TLAC) is a crucial capital regulation requiring financial institutions to maintain additional capital, which includes common equity, equity-like instruments, and subordinated debt such as CoCos The TLAC ratio, expressed as a percentage of Risk-Weighted Assets (RWA), mandates a minimum of 16% starting January 1, 2019, increasing to 18% by January 1, 2022 Additionally, TLAC must constitute at least 6% of the Basel III leverage exposure from January 1, 2019, and rise to 6.75% by January 1, 2022 While there are no varying requirements across different risk buckets, Global Systemically Important Banks (G-SIBs) based in emerging markets, specifically Chinese G-SIBs, face less stringent requirements and a longer phase-in period.

In addition to Basel III, the enhanced regulatory framework for G-SIBs also includes:

• ‘Tougher liquidity standards’ and more ‘proactive and intensive supervision consistent with the risks an institution poses to the financial system’;

• ‘An effective resolution framework with tools to enhance orderly recovery and wind- down in the event of failure, including effective burden-sharing with the private sector

22 Financial Stability Board (FSB) (9 November 2015).

131 through debt that can be bailed in, cross-border arrangements, and firm-specific structural measures as needed’;

• ‘Enhanced transparency and disclosure to improve market discipline and monitoring’;

• ‘Strengthened market infrastructure to limit the risks of contagion arising from inter-and connectedness and the limited transparency of counterparty relationships.’ 23

This final chapter summarises the previous chapters of Pt I (see Sect 8.1) and highlights the main future challenges with regard to TBTF in banking (see Sect 8.2).

Summary

Chap 3: Introduction to Too-Big-to-Fail in Banking

A bank is deemed "Too Big To Fail" (TBTF) when the government recognizes the necessity of protecting the nation's financial system and economic stability from potential disruptions that could arise from the bank's default This involves guaranteeing the repayment of the bank's uninsured liabilities The systemic risk associated with Global Systemically Important Banks (G-SIBs) stems from their potential to contribute to financial contagion and their vulnerability to macroeconomic shocks.

The United States exemplifies the concept of "Too Big to Fail" (TBTF), particularly highlighted by the 1984 bailout of Continental Illinois National Bank and Trust Company However, the origins of the TBTF doctrine trace back much earlier, manifesting similarly across developed economies In the US, the banking regulatory framework evolved gradually over more than a century, shaped by a series of economic crises that necessitated legislative responses Key developments during this period include the establishment of deposit insurance and the lender-of-last-resort (LOLR) system between 1913 and subsequent years.

In 1933, the United States introduced separate measures aimed at stabilizing the banking system in response to financial crises Both initiatives successfully achieved their original goals, but a significant shift occurred when deposit insurance was managed by an institution empowered to intervene with struggling banks in the short term through lender of last resort (LOLR) actions and, eventually, through long-term open-bank assistance This evolution marked a pivotal change in the federal government's approach to banking stability.

The conclusion highlights the natural tendency to support large banks to mitigate losses from insured events, leading to bailouts for bigger institutions while smaller banks were left unsupported This scenario unfolded alongside increasing deregulation in the banking sector and the removal of implicit size restrictions, which altered market incentives and transformed the banking landscape Additionally, the growing size and complexity of banks made timely resolutions more challenging, posing a risk to the overall stability of the banking system As a result, the criteria for banks to receive assistance became increasingly lenient, creating a dangerous cycle of dependency.

The deregulation of the banking sector, coupled with increased government intervention, fostered the emergence of the "Too Big to Fail" (TBTF) phenomenon This contradictory regulatory landscape disincentivized banks from addressing TBTF risks, leading to the initial major bailouts Over time, TBTF became ingrained in banking regulation, evolving through the precedent of rescuing individual troubled banks rather than through deliberate policy choices Consequently, regulatory attempts to eliminate TBTF were often overlooked during prosperous periods in the banking system It was only during the global financial crisis (GFC) that the significant rise in TBTF risks from the preceding decade became apparent.

Chap 4: TBTF Causal Chain: Explicit and Implicit Government Guarantees

The history of "Too Big To Fail" (TBTF) highlights how conflicting governmental goals often result in the provision of safety nets for banks This creates an incentive for banks to expand, taking advantage of public subsidies and increasing their likelihood of receiving such support Once banks reach a size deemed TBTF, it becomes challenging to address the disincentives that arise, as TBTF entities tend to perpetuate the phenomenon The two primary drivers of TBTF are explicit government guarantees (EGG) and implicit government guarantees (IGG).

There are no established criteria for the scope and practices of EGGs, often referred to as G-SIB bailouts Governments prioritize economic stability and the prevention of financial system disruptions by ensuring the continuity of a bank's operations To support lending to the real economy, it is essential for banks to maintain access to various funding markets This access relies on the trust of the bank's creditors, which the government fosters by guaranteeing the prompt repayment of uninsured liabilities.

In practice, deposit coverage is typically extensive, while coverage for other debt instruments is less comprehensive, influenced by the political economy of banking Equity instruments usually lack guarantees, as their holders are anticipated to have a greater capacity to absorb significant losses.

IGGs extend deposit insurance to uninsured bank liabilities without requiring premium payments from insured G-SIBs, allowing these banks to transfer potential loss liabilities to the state This selective government intervention distorts market forces and creates moral hazards among bank stakeholders, particularly influencing creditor behavior As a result, all liability holders expect protection during bailouts, leading to lower funding costs and larger counterparty positions for G-SIBs, evidenced by improved credit ratings and reduced CDS spreads Additionally, IGGs reduce creditor monitoring, further exacerbating bank moral hazard and prompting G-SIBs to engage in riskier behaviors and pursue aggressive growth strategies The existence of shareholder moral hazard in relation to IGGs remains ambiguous, as bank equity is typically unprotected and stringent TBTF regulations can negatively impact equity returns.

Chap 5: Public Cost and Benefits of TBTF

This chapter shifts focus from the impact of EGGs and IGGs on bank stakeholders to their welfare implications for society, highlighting that public subsidies for G-SIB stakeholders impose costs on the broader community G-SIBs that fail to internalize the full costs associated with IGGs and EGGs contribute to inefficiencies, resulting in overproduction and suboptimal market outcomes detrimental to societal welfare Consequently, the TBTF doctrine can be likened to 'banking pollution' within the framework of environmental economics Furthermore, conducting a cost-and-benefit analysis of the TBTF doctrine to assess the sources of this imbalance is recognized as inherently subjective and may differ significantly across countries and over time.

Current research suggests that the optimal scale for banks is approximately US$ 100 billion in total assets, which remains advantageous for both the public and bank stakeholders Beyond this threshold, banks may experience diminished returns, inefficiencies, and increased deadweight costs, indicating that any growth is primarily motivated by management or shareholder interests rather than public welfare A key factor in this excessive growth is the concept of "Too Big To Fail" (TBTF) scale economies, as banks exceeding US$ 100 billion in assets are often classified as TBTF While these quantitative benchmarks are approximate, Global Systemically Important Banks (G-SIBs) tend to operate at sizes that may be excessively large.

136 8 Conclusion micro-level perspective of bank efficiency and from the macro-level perspective of systemic risk.

The implementation of Global Systemically Important Banks (G-SIBs) demonstrates that the benefits of Enhanced Global Governance (EGG) significantly outweigh the associated costs, especially when considering the potential GDP losses that could occur without G-SIB rescue measures While bailouts are typically one-time events, the true social costs of a "Too Big to Fail" (TBTF) policy manifest primarily in advance and indirectly through Implicit Government Guarantees (IGG), which create distorted incentives for banks and lead to anticipated crisis costs Thus, the issues stem from IGGs, as they serve as the foundation for the challenges posed by EGGs.

The persistence of the Too Big to Fail (TBTF) doctrine is primarily rooted in government decision-making processes, which are often swayed by the immediate need to appeal to voters and the phenomenon of 'time inconsistency.' This 'time inconsistency' occurs when policymakers focus on the short-term effects of economic growth goals (EGGs) while disregarding their prior commitments to avoid government intervention.

The previous chapter highlights that the social costs associated with "Too Big to Fail" (TBTF) banks exceed their private costs, as bank management decisions, while rational individually, contribute to systemic risk that surpasses socially optimal levels This situation underscores a market failure that necessitates government intervention through regulation, compelling banks to account for the social costs of their TBTF status Consequently, current proposals focus primarily on crisis prevention, which is one of the three key pillars of banking crisis policy, alongside crisis management and crisis resolution.

Enhancing market discipline serves as the primary defense against financial crises by fostering the intrinsic motivation of bank stakeholders to effectively manage and oversee their institutions This approach minimizes the risks associated with regulatory challenges, such as regulatory arbitrage To bolster market-driven crisis prevention, improving corporate governance and increasing supervision of Global Systemically Important Banks (G-SIBs) are essential strategies.

Outlook

Improved Research on and Regulation of TBTF

The Global Financial Crisis (GFC) significantly advanced the understanding of the "Too Big to Fail" (TBTF) issue, establishing it as a key public policy concern alongside financial stability Research following the GFC has largely convinced academics that TBTF represents a negative externality in the financial system, contributing to the crisis's severity and possibly its onset While some scholars argue that globally systemically important banks (G-SIBs) may offer social benefits, the prevailing literature strongly indicates the detrimental effects of TBTF, particularly in rapidly changing banking environments and measurement challenges Further investigation into these areas is essential, especially considering the enormous costs associated with potential future financial crises exacerbated by TBTF, and the effectiveness of recently implemented policy tools remains uncertain.

Since the implementation of regulatory measures following the Global Financial Crisis (GFC), banks are now more stable and less likely to fail, thanks to larger capital buffers and improved liquidity positions Frequent regulatory stress tests highlight the enhanced resilience of the banking sector, while Global Systemically Important Banks (G-SIBs) have seen a reduction in public subsidies due to effective resolution regimes and burden-sharing arrangements These changes not only lower potential bankruptcy costs for G-SIBs but also streamline the exit of inefficient banks from the market In response, some G-SIBs have scaled back specific activities Additionally, bank balance sheets worldwide have contracted due to statutory requirements linked to government capital injections and increased capital demands Overall, these policy initiatives are deemed necessary and adequate to tackle the immediate challenges faced by the banking sector.

TBTF Has Not Been Abolished

Despite regulatory efforts, Global Systemically Important Banks (G-SIBs) continue to exist and operate with largely unchanged business models, which means they will inevitably face challenges.

The existence of 139 international bankruptcy laws complicates the effective resolution of large international banks, with many resolution regimes being untested or applied inconsistently The exit of large, inefficient banks poses significant risks to the financial sector's overall health, particularly during weak economic conditions, potentially disrupting the real economy For mega-banks, even the most advanced resolution plans are challenging and time-consuming to implement Consequently, some investors may incur substantial losses, impacting other stable institutions and possibly the entire market As indicated by the concept of "Too Big To Fail" (TBTF), genuinely Global Systemically Important Banks (G-SIBs) are unlikely to be permitted to fail.

Current financial market regulations prioritize stability over fostering fair competition, a shift that emerged after the Global Financial Crisis (GFC) Regulators opted for increased safety through more stringent regulations, which have significantly raised compliance costs across the banking sector, particularly impacting smaller banks This has potentially led to an increase in the socially optimal size of banks Reflecting on the pre-GFC period, the banking industry in developed countries suffers from overcapacity, inflated costs, and insufficient profits Unlike other industries where stronger firms acquire weaker ones, the banking sector faces regulatory resistance to both mergers and bankruptcies, leaving regulators in a challenging position between managing Global Systemically Important Banks (G-SIBs) and preventing bank failures.

Current regulations are insufficient for long-term stability, as they are vulnerable to changes in the economic and financial landscape These new policies introduce complexity and inconsistencies within the adaptive banking system, leading to potential inefficiencies and instabilities in the future Notably, there is a trend of financial activities migrating from the regulated banking sector to the unregulated shadow banking sector In certain loan markets, insurance companies and credit funds have become the sole providers of debt capital Additionally, the growth of less regulated financial entities, such as asset managers, raises concerns, particularly as a growing portion of assets is managed passively.

Current TBTF regulations fail to address significant issues related to political economy and time-inconsistency, as policymakers often prioritize short-term interests and survival This tendency leads to a consistent pattern of bank bailouts for immediate gains, raising doubts about the sustainability of efforts to eliminate TBTF.

A notable instance within the EU involves the public bailout of Banca Monte dei Paschi di Siena in Italy, highlighting differing approaches to bank rescues In contrast, the Spanish bank Banco Popular was not granted public rescue measures, illustrating the varied responses to financial challenges across Europe.

8 Cf U.S Government Accountability Office (GAO) (16 January 2013), Monopolkommission (9 July 2014), and Varmaz, Fieberg, and Prokop (2015).

Years after the Global Financial Crisis (GFC), the global economy has achieved significant growth, and the issue of "Too Big to Fail" (TBTF) has faded from the spotlight Governments worldwide are experiencing 'regulatory fatigue' and are increasingly advocating for a rollback of stringent regulations on large banks, particularly in the United States.

Breaking up G-SIBs Must be the Next Step

The lessons learned from the Global Financial Crisis (GFC) must not be forgotten, as history shows that the next crisis is inevitable; the real question is whether we will be prepared for it While it is impossible to predict the exact source of future crises, we can take steps to prevent them from being exacerbated by the "Too Big To Fail" (TBTF) doctrine Historically, measures intended to alleviate a crisis often lead to new ones In response to the GFC, central banks have maintained ultra-low interest rates to stimulate the economy, which has resulted in inflated asset values as investors search for yield This has created asset bubbles that could potentially trigger another crisis Additionally, global debt levels have reached unprecedented heights, particularly in emerging markets like China, where the largest banks operate with less regulation and engage in risky practices reminiscent of those seen in developed countries prior to the GFC.

Maintaining and extending a strong capital regime to developing countries and non-bank financial firms is essential While larger capital buffers can decrease the likelihood of failures among Global Systemically Important Banks (G-SIBs) and mitigate banking crises, they cannot fully internalize social costs associated with banking operations Ultimately, effective bank management is more crucial than capital; a well-run bank thrives without excessive capital, whereas poor management cannot be salvaged by capital alone Additionally, the adoption of price-based regulation for capital surcharges has been influenced by political considerations and implemented with caution in light of a fragile economic climate.

The current strength of the wider economy presents an opportunity for bold, transformative actions to address the fundamental issues of privatized profits and socialized risks The concept of "too big to fail" (TBTF) highlights the need for a break-up of large institutions, as internalizing social costs is only feasible through this approach Since systemic risk is inherently linked to the size of banks, promoting smaller institutions is essential to mitigate risks within the banking system.

13 Cf Haldane (2012) and Kashkari (16 February 2016).

To effectively address the "Too Big to Fail" (TBTF) issue in banking, it is crucial for regulatory measures to mandate the breakup of Global Systemically Important Banks (G-SIBs) Such restrictions are essential as they help mitigate the social risks associated with potential banking crises, outweighing the private costs linked to reduced economies of scale and scope Banks must be allowed to take risks to foster growth and innovation, while also having the ability to exit the market if they become inefficient Additionally, smaller and less complex banks facilitate simpler regulations that can lead to more sustainable changes in banking behavior However, the immediate costs of implementing such regulations, like liquidity constraints, may be significant and could surpass the expenses of increasing capital buffers The challenge lies in determining appropriate size limits for banks in a rapidly changing industry, balancing the advantages of scale with the potential for systemic risk These limits could be linked to a country's gross domestic product (GDP), promoting further financial integration Current research indicates that many banks exceed the socially beneficial size, highlighting the need for regulatory bodies to address these concerns rather than relying solely on market forces.

Part II Quantifying the Shareholder Value of Too-Big-to-

This chapter of the empirical section of the thesis, titled Pt II, provides a summary of existing research focused on relevant quantitative analysis, addressing the overarching research question of the dissertation.

What drives the valuation of stocks of G-SIBs compared to stocks of other banks over time?

This article explores several key research directions regarding the impact of the Too Big To Fail (TBTF) doctrine on bank equity and stocks Section 9.1 reviews conclusions from similar studies, while Section 9.2 highlights recent recommendations for regression analysis that incorporate both firm and time effects Additionally, Section 9.3 focuses on the latest findings concerning the input factors for regression, identifying the most effective relative valuation measure for banks as the dependent variable and examining how this measure is best explained by fundamental bank metrics as independent variables.

Impact of TBTF on Equity

The behavior of stakeholders in Global Systemically Important Banks (G-SIBs) can be influenced by competitive advantages from Emerging Growth Companies (EGCs) and Innovative Growth Companies (IGCs), as well as by regulations specifically aimed at G-SIBs While numerous empirical studies have explored the effects of the "Too Big to Fail" (TBTF) doctrine on creditor and bank behavior, particularly regarding bank debt and asset risk, there is a notable scarcity of research on shareholder moral hazard related to TBTF This gap may arise from two factors: primarily, creditors are the main beneficiaries of bailouts, leading to a more predictable outcome, whereas the effects on shareholders remain uncertain due to varying competitive advantages and disadvantages.

Research related to the equity of Global Systemically Important Banks (G-SIBs) indicates that assessing the impact on bank assets and funding is more straightforward than evaluating equity Unlike equity, loans and issued liabilities typically have a par repayment value, making them more comparable across different banks.

The TBTF doctrine presents two distinct sources of value impacts: EGGs in bankruptcy scenarios and IGGs for ongoing concerns While empirical studies primarily focus on the latter, they can be classified based on the research methodologies employed.

1 Translation of TBTF funding benefits (see Sect 9.1.1): One study examines privi- leged funding as the only source of potential shareholder benefits from TBTF.

2 TBTF premiums in precedent M&A transactions (see Sect 9.1.2): Three studies examine takeover premiums for large banks where the new combined entity became TBTF.

3 TFTF sum-of-the-parts (see Sect 9.1.3): One secondary source, an equity research report, calculates the value of one G-SIB by comparing the valuation of its business units with average relative valuation measures (P/E) of non-G-SIB competitors.

4 Share-Price Reactions to TBTF Events (see Sect 9.1.4): Many share-price reaction studies evaluate the positive or negative impact of certain events or periods on the absolute value of G-SIBs Some of these studies analyse a comprehensive set of global G-SIBs by using the G-SIB designation.

Research methodologies can be classified based on their outcomes and approaches Categories 1 and 2 focus on quantifying the absolute value impact, both concluding that speculative "too big to fail" (TBTF) guarantees positively influence bank valuations In contrast, category 3 utilizes secondary research to compare the relative values of Global Systemically Important Banks (G-SIBs) against non-G-SIBs, revealing a negative relationship Meanwhile, category 4 does not provide quantifiable value impacts in absolute terms.

Research on compensation payments to shareholders of Global Systemically Important Banks (G-SIBs) following government bailouts is scarce During the Global Financial Crisis (GFC), governments generally avoided fully taking over G-SIBs, opting instead to inject preference shares rather than expropriating common shares According to M R King (2009b), U.S and EU government capital injections allowed G-SIB shareholders to retain their (diluted) shares and potentially benefit from future share price recoveries, despite many shares losing value over time Notably, in the UK, certain bailed-out banks, such as Northern Rock, Bradford & Bingley, and Anglo Irish Bank, saw their shareholders expropriated immediately.

This research focuses on the impact of significant "too big to fail" (TBTF) events on share price movements, highlighting both positive and negative effects for shareholders of globally systemically important banks (G-SIBs).

9.1.1 Translation of TBTF Funding Benefits

As described in Sect 4.2.3, G-SIBs generally enjoy lower funding costs.

In their July 2013 analysis, Tsesmelidakis and Merton explore the translation of funding benefits into advantages for shareholders and debtholders, revealing that banks leverage their "Too Big To Fail" (TBTF) status to enhance their funding strategies Their study of 27 US banks from January 2007 to September 2010 shows a preference for short-term, fixed-rate debt, diverging from the typical trend of opting for long-term, non-guaranteed debt in uncertain conditions By calculating the model-market spread difference of credit default swaps (CDS), they quantify the guarantee's value in basis points, highlighting that shareholders gained US$ 121.3 billion at debt issuance due to improved terms, while debtholders benefited from US$ 202.9 billion over the debt's lifespan Notably, shareholders reaped the most benefits from bond issues following the announcement of rescue programs and heightened market expectations of TBTF, particularly between Q4 2008 and Q2 2009.

9.1.2 TBTF Premiums in Precedent M&A Transactions

Banks pursue "Too Big to Fail" (TBTF) status to gain associated benefits, as discussed in Section 4.2.4 They can reach the necessary scale through organic growth or mergers and acquisitions (M&A) This article examines the implications of M&A transactions in relation to achieving TBTF status.

Kane (2000) conducts an event study on bank mega-mergers from 1991 to 1998, revealing that stockholders of large-bank acquirers experience increased value when the target deposit institution is substantial and located in the same state He concludes that the "Too Big to Fail" (TBTF) doctrine has skewed deal-making incentives for megabanks, allowing them to transfer unaccounted risks onto taxpayers due to their high leverage.

Brewer III and Jagtiani (2013) conducted an analysis of data from 1991 to 2004 to estimate the value of the Too Big to Fail (TBTF) subsidy Their findings reveal that banking organizations are willing to pay a significant premium for mergers that increase their asset sizes beyond commonly recognized TBTF thresholds, with this premium estimated at approximately US$9.1 billion.

15 to 23 billion that 8 banks in the dataset were willing to pay for acquisitions that enabled them cross the established threshold of US$ 100 billion in total assets.

• Molyneux, Schaeck, and Mi Zhou (2014) analyse precedent European transactions between 1997 and 2008 Their results indicate that merger premiums ‘are positively associated with a higher possibility of becoming TBTF’.

Research has not definitively established a connection between premiums and the "Too Big to Fail" (TBTF) designation, leaving room for alternative explanations or synergies Additionally, the total value of benefits associated with TBTF is likely underestimated for two main reasons: first, banks aiming to leverage TBTF advantages are unlikely to fully transfer these benefits to the shareholders of their acquisition targets; second, the TBTF advantages already realized before a merger cannot be captured by event studies.

9.1.3 TBTF Sum-of-the-Parts

Banks achieve TBTF size not only by upscaling the volume of business activities in one segment, but also by extending the scope of business activities to include other segments

In many cases, each of the businesses would not individually be considered TBTF.

Goldman Sachs' equity research report (5 January 2015) evaluates the effects of the G-SIB designation on J.P Morgan Chase by employing a sum-of-the-parts analysis based on the P/E ratios of its pure-play competitors The report estimates the bank's potential value without G-SIB status, factoring in the benefits of excess capital returns from reduced capital requirements following a hypothetical bank break-up It also accounts for the loss of synergies and execution risks associated with the split The resulting difference between the estimated value and the actual market value represents the potential G-SIB discount, which ranges from 4 percent to 25 percent based on the assumptions used in the analysis.

9.1.4 Share Price Reactions to TBTF Events

The research papers considered in this section are based on event study methodologies 4 that test the TBTF hypothesis They focus on the abnormal stock returns of large banks

4 Described by Fama et al (1969) and MacKinlay (1997).

The analysis of 149 Global Systemically Important Banks (G-SIBs) compared to a random control group reveals significant investor reactions to Too Big To Fail (TBTF) events, such as government announcements and bailouts These events provide crucial information that influences investor behavior The studies conducted on this topic are classified based on their findings, highlighting four distinct primary effects related to TBTF events.

1 TBTF designation effect: Describes the direct or indirect designation of certain banks as TBTF by an official body and potential positive abnormal reactions of the banks’ share prices.

Two-Way Fixed-Effect Regression Analysis

This section, along with Sect 9.3, introduces the methodology for the quantitative aspect of this dissertation In empirical economics, the single-equation linear model remains a fundamental methodology For panel data, which includes complete observations across multiple firms and periods, the basic regression model is represented as Y_it, where this variable is explained by the regressor X_it When X_it is available for all firms (i) and periods (t), the model can be analyzed as an ordinary linear model The coefficients (β) are estimated using the ordinary least squares (OLS) method, which provides unbiased standard errors when the residuals (u) are independent and identically distributed.

When a firm's residuals show correlation over time, it indicates an unobserved firm effect, while correlation of residuals across different firms in a given year signifies an unobserved time effect These effects lead to biased standard errors that overlook valuable information, suggesting that at least one explanatory factor is missing, resulting in the coefficients being either over- or under-estimated.

In finance research, panel data analysis is prevalent, with various methods proposed for estimating standard errors when residuals are correlated across firms or years Two primary approaches exist: one involves addressing one dimension parametrically, such as using binary (dummy) variables, while clustering standard errors on the other dimension; the second approach addresses both dimensions parametrically When there are enough clusters in each dimension, the standard errors remain unbiased, leading to accurately sized confidence intervals, regardless of whether the firm and time effects are permanent or temporary.

In a study by Petersen (2009), it was found that 42% of papers utilizing panel data failed to adjust standard errors for potential dependence in residuals Additionally, among the remaining papers, 34% employed the Fama-MacBeth procedure to estimate both coefficients and standard errors.

9.2 Two-Way Fixed-Effect Regression Analysis

Recent advanced econometric guides advocate for the use of the entity-and-time-fixed effects model, also known as the two-way fixed-effect model In this framework, the coefficients are often termed difference-in-differences estimators The model can be formally expressed with α i representing the entity-fixed effect, t denoting the time-fixed effect, and u it as the error term.

Equation 9.2 can equivalently be represented using n−1 entity binary indicators and T−1 time binary indicators (along with an intercept and unknown coefficients β0,β1,γ2, .,γ n , and δ2, .,δ T ):

The coefficients can be estimated using the least squares dummy variables (LSDV) method.

Relative Bank Valuation and Explaining Factors

This section builds on the regression model framework established in Section 9.2 by exploring potential input variables, with a focus on a relative bank-valuation measure, specifically the Price-to-Book Value (P/BV) ratio The literature provides both theoretical and empirical models to explain this valuation measure Recent research indicates that the identified value drivers can be enhanced for practical application by incorporating banks' intangible assets.

Y it =β 0 +β 1 X it +γ 2 D2 i + ã ã ã +γ n Dn i +δ 2 B2 t + ã ã ã +δ T BT t +u it

In research methodologies, 29% of studies utilize dummy variables for each cluster, such as fixed effects or within estimation The next most prevalent approaches employ Ordinary Least Squares (OLS) or similar methods to estimate coefficients, while adjusting standard errors for intra-cluster correlation, particularly within firms or industries Additionally, 7% of studies apply the Newey-West procedure, tailored for panel data, to adjust standard errors Meanwhile, 23% report clustered standard errors, which are White standard errors modified to account for potential intra-cluster correlation, often referred to as Rogers standard errors in financial research.

20 Wooldridge (2001) Cf., for technical explanation and matrix notation Thomas (2003, 39–51).

Section 2.2 shows the common valuation methods for banks According to the overview of bank-valuation methods provided in Table 2.1, banks can be valued on a relative-market basis—that is, without further strategic value considerations—with the help of either market multiples or regressions based on market multiples.

Relative valuation requires standardizing prices, typically by converting them into ratios For banks, the most prevalent relative-valuation measures are the price-to-earnings ratio (P/E) and the price-to-book value ratio (P/BV), commonly referred to as trading or market multiples According to Dermine, these ratios serve as essential tools for assessing bank valuations.

(2014), shows the close relation between the two ratios (where n is the number of shares,

PPS is the price per share, EPS is the earnings per share, and BVS is the book value per share, which equals equity/n):

The Price-to-Book Value (P/BV) ratio is derived from the Price-to-Earnings (P/E) ratio and Return on Equity (RoE), both of which are influenced by anticipated future earnings growth Earnings, as defined by bank accounting standards, can be affected by management discretion and accounting practices, leading to potential biases and fluctuations unrelated to the firm's intrinsic value P/BV serves as a complementary metric to P/E by incorporating RoE, which reflects a more stable measure of a bank's performance through its book value of equity Ultimately, P/BV encapsulates market expectations regarding a bank's capacity to generate excess profits from its capital while considering future growth potential, making P/E more relevant for banks where growth is the primary driver of value.

Tobin (1969) introduced the concept of Tobin's q, which is the ratio of the market value of assets and liabilities to their replacement or reproduction costs However, obtaining accurate replacement costs can be challenging in practice As a relative metric, Tobin's q is most effective when applied across multiple firms to ensure comparability and relevance Consequently, many researchers have since adapted the original concept of Tobin's q for practical applications.

22 Cf Jordan et al (2011, 2049), Dermine (2014), and Fairfield (1994, 30).

9.3 Relative Bank Valuation and Explaining Factors

In financial analysis, the cost of related research or reproductions and accounting book values are often utilized due to their accessibility and reliability as proxies The Price-to-Book Value (P/BV) ratio is calculated by excluding liabilities, reflecting the market valuation of a firm relative to its net asset value, which is the difference between the book value of assets and liabilities Some scholars advocate for the reverse calculation, known as Book-to-Market Value (BV/P) Both P/BV and BV/P serve as equivalent indicators of value creation, which can be assessed through Tobin’s q, a relationship that has been empirically validated.

Price-to-Book Value Ratio ( P/BV )

The Price-to-Book Value (P/BV) ratio is widely regarded as the most accurate valuation metric for banks, effectively predicting profitability, earnings, and stock returns This ratio is particularly relevant for banks due to the high explanatory power of their book value assets, which are often marked-to-market or valued using sophisticated internal models A P/BV ratio below one suggests that the market anticipates the firm will struggle to convert its balance sheet assets into profits, indicating potential losses and a decline in book value Conversely, a ratio above one signifies a strong franchise value that can be realized from the company's assets and liabilities Despite its stylized conclusions, investors favor the P/BV ratio for banks due to its intuitive nature, even in scenarios where earnings may be temporarily negative.

Price-to-Book Value Regression ( P/BV − RoE )

When utilizing the relative Price-to-Book Value (P/BV) valuation metric, it is essential to select comparable banks that share similarities in profitability, risk, and growth Given that no two firms are identical, it is important to account for their differences Financial analysts frequently employ regression analyses to achieve this, with the simple bivariate P/BV-RoE regression being the most prevalent, where P/BV serves as the dependent variable.

The book value of an asset is calculated by subtracting allowable depreciation from its original purchase price, leading to a decrease in value over time In contrast, the book value of a liability reflects its value at issuance and is typically more stable While the market value of an asset can fluctuate significantly based on its earning potential, the book value of a liability tends to remain closer to its par value, as it must be repaid at that amount.

25 Varaiya, Kerin, and Weeks (1987, 496) Cf Damodaran (2012).

26 Cf Park and Lee (2003, 331) and Imam, Barker, and Clubb (2008, 517).

The article discusses how Return on Equity (RoE) can explain 159 variables, particularly in assessing whether a bank is fairly valued compared to its peers An illustrative graphical regression analysis is presented, where the slope of the regression line is represented by the Price-to-Earnings (P/E) ratio Banks positioned above this regression line are considered overvalued relative to their counterparts, while those below are seen as undervalued This regression analysis leverages the strong empirical correlation between market valuation, measured by Price-to-Book Value (P/BV), and profitability as indicated by RoE, warranting a deeper exploration of this relationship.

Explaining valuation—in particular, in terms of P/BV (or BV/P)—is one string of research in a long history of asset pricing: a core focus of capital markets research 31

Williams (1938) is widely considered to be the first to formulate an essential relationship that every investor nowadays acts upon naturally:

Fig 9.2 Illustrative Graphical P / BV − RoE Regression

30 The P / BV − RoE regression is explained in detail by Wilcox (1984) and Wilcox and Philips (2005).

31 An historical overview of asset pricing is provided by e.g., Dimson and Mussavian (1999), Çelik

(2012), Royal Swedish Academy of Sciences (14 October 2013), and Shih et al (2014).

9.3 Relative Bank Valuation and Explaining Factors

A stock's value is determined by the present value of all future dividends it will pay, with no additional factors influencing this worth Current earnings, financial health, and market conditions only play a role in helping investors assess potential future dividends, ultimately guiding their buying and selling decisions.

Gordon and Shapiro (1956) expanded upon the foundational work of Williams (1938) to establish the dividend discount model (DDM), also known as the Gordon growth model They formalized this framework by defining the price of an asset, P0, as its value at time t=1, while DVt represents the expected dividend at time t Additionally, the cost of equity (CoE) reflects the required rate of return for investors, aligning the asset's anticipated future payments with its current price.

Eq 9.5 more easily, it can be rewritten when the dividend is assumed to be received and discounted on a continuous basis:

A firm is anticipated to retain a portion, denoted as b (the retention rate, calculated as 1 minus the payout ratio), of its net income, E t, while distributing the remaining amount as dividends, DV t.

Second, a firm is expected to earn a return, RoE, on its book value, BV t :

Assuming a constant RoE over time, the income, E, at time t is the income at (t−1) plus

RoE percent of the income at (t−1) retained:

Equation 9.9 is simply a compound interest expression so that, if E t grows continuously at the rate g=RoE×b,

Substituting this expression for D t in Eq 9.6 and integrating gives the formula that is known in finance as perpetuity:

Decomposition of Price-to-Book Value ( P / BV )

To arrive at P/BV, book value, BV, is added in the next steps 32 We can substitute the dividends, DV 0, with Eq 9.7 and receive,

Equation 9.8 can be rewritten as E 0=BV 0 RoE, and inserted into the following term:

Equation 9.14 can be rewritten to represent the so-called residual-income model (RIM) or the economic-value added model (EVA), in which the firm distributes the amount that it earns above its cost of capital:

Equation 9.14 can also be rewritten in terms of the P/BV:

Here it can be seen that the P/BV is an increasing function of the return on book equity,

Research Gaps vs Research Objectives

The following highlights of this empirical study point out the research gaps and the main characteristics of the analysis undertaken to close them:

This study analyzes the valuation differences between Global Systemically Important Banks (G-SIBs) and non-G-SIBs using an advanced measure, specifically the Price to Tangible Common Equity (P/TCE) Previous research indicates that G-SIBs are valued differently in the market, primarily due to the Too Big To Fail (TBTF) doctrine, which influences factors such as funding advantages and regulatory burdens However, there is a lack of comprehensive studies focusing on the valuation discrepancies between G-SIBs and non-G-SIBs To address this gap, the research employs a refined version of the Price to Book Value (P/BV) metric, as traditional measures may overlook the impact of intangible assets By utilizing tangible book value (TBV) in the regression analysis, this study aims to enhance the understanding of how G-SIBs are valued compared to their non-G-SIB counterparts.

The regression analysis of the hypothesis development indicates that tangible common equity (TCE) serves as a more accurate measure than tangible book value (TBV), as it excludes non-equity instruments not reflected in market price (P), such as minority interests and hybrid capital It is posited that the explanatory power of regressing P/TCE surpasses that of P/BV or P/TBV when utilizing the same explanatory variables Notably, while prior primary studies have not employed P/TCE in their methodologies, it is a common practice among investment banking professionals.

The Financial Stability Board (FSB) has identified around 30 Global Systemically Important Banks (G-SIBs), although there is no universally accepted definition for these institutions This designation comes with significant additional regulatory obligations, which have been explored in various studies.

To effectively analyze the impact of "Too Big to Fail" (TBTF) on equity, it is essential to control for external factors by utilizing decomposed fundamentals derived from theory, specifically focusing on profitability (RoE), cost of equity (CoE), and growth (g) Previous studies often overlook these exogenous influences due to their short-term analysis scope, but a comprehensive examination over time necessitates excluding variables beyond the G-SIB designation While existing research presents varied findings regarding the empirical explanation of price-to-book value (P/BV), two key observations emerge: first, RoE, CoE, and g consistently serve as primary determinants, and second, a detailed decomposition of these factors, particularly RoE, enhances the explanatory power of regression analyses This study adopts a structured methodology to identify optimal explanatory variables by rigorously decomposing price-to-tangible common equity (P/TCE) in line with theoretical frameworks, while also factoring in off-balance sheet bank income.

This study employs an advanced econometric model, specifically a two-way fixed-effect regression, to analyze the impact of "Too Big to Fail" (TBTF) on equity over a continuous period from 2008 to 2015 Unlike previous empirical studies that focus on isolated time points, this research examines quarterly data, aligning with the financial reporting frequency of many banks The analysis spans from the establishment of the Financial Stability Board (FSB) on November 17, 2008, to just before the European Banking Authority's (EBA) first publication of the list of Other Systemically Important Institutions (O-SIIs) on April 26, 2016, incorporating significant designation and regulation events during this timeframe.

The introduction of Other Systemically Important Institutions (O-SIIs) has blurred the lines between Global Systemically Important Banks (G-SIBs) and domestic systemically important banks (D-SIBs), leading to confusion in the banking sector Notably, some banks, such as ING and Nordea, face a higher D-SIB surcharge of 2 percent compared to their 1 percent G-SIB surcharge, highlighting the complexities in regulatory frameworks.

In some cases, it is lower (for instance, BNP Paribas with a 1.5 percent D-SIB surcharge against a G-SIB surcharge of 2 percent).

The study focuses on 173 Global Systemically Important Banks (G-SIBs) and aims to identify both entity- and time-fixed effects related to quarterly valuation developments To achieve this, a two-way fixed-fixed regression model will be employed, marking a novel approach in finance research as it has not been previously utilized in academic studies.

This study aims to analyze a global sample of Global Systemically Important Banks (G-SIBs) using the advanced SNL Financial database, which is favored by professional bank analysts but underutilized in academic research Previous empirical studies on Price-to-Book Value (P/BV) ratios have primarily focused on regional bank samples, particularly from the US and Europe, and often span limited time periods of less than three years These constraints are largely due to outdated databases and restricted data availability, which can hinder the explanatory power of regression models By employing a more comprehensive and sophisticated dataset, this research seeks to enhance the robustness of its findings and provide a broader understanding of P/BV across various banking institutions.

Research Hypotheses

There is a lack of academic sources on the relative valuation of Global Systemically Important Banks (G-SIBs), with only one equity research source available The theoretical implications of how implicit government guarantees (IGGs) affect relative valuation remain ambiguous, as IGGs present both advantages, like funding benefits, and disadvantages, such as increased regulation Consequently, this dissertation is framed by a non-directional hypothesis.

• Hypothesis 1: G-SIB designation distorted G-SIBs’ P/TCE from Q2 2008 to Q3 2015.

With regard to the evolution of the hypothesised valuation difference, two further hypotheses shall be established:

An event study reveals that Global Systemically Important Banks (G-SIBs) experienced significant abnormal gains in share prices following the unofficial designation event on November 30, 2009 This phenomenon is likely influenced by the "Too Big To Fail" (TBTF) designation effect, while subsequent regulatory events led to abnormal losses These findings support the directional hypothesis.

• Hypothesis 2: G-SIBs’ P/TCE is more favorable in Q4 2009 than non-G-SIBs’

P/TCE in the same quarter (i.e G-SIBs’ P/TCE improved more than non-G-SIBs’

One academic working paper 5 calculates that the average G-SIBs’ long-term share-price development lags significantly behind that of non-GIBs’ between 1 November 2009 and

As of 31 October 2012, following the initial designation event, the analysis does not account for fundamental factors This oversight may stem from the growing clarity surrounding additional regulatory requirements for Global Systemically Important Banks (G-SIBs), particularly capital surcharges, which are likely contributing to their underperformance Therefore, we propose the following directional hypothesis.

• Hypothesis 3: G-SIBs’ P/TCE worsened more than non-G-SIBs’ P/TCE between Q4

Extensive research has explored both theoretical and empirical aspects of Price-to-Book Value (P/BV) and its components, including Return on Equity (RoE), Cost of Equity (CoE), and growth rate (g) Recent studies highlight the lack of explanatory power of intangible assets in this context Consequently, the research method of this dissertation is shaped by three directional hypotheses that build on these foundational findings.

• Hypothesis 4: A bank’s P/TCE is positively associated with the decomposition of

– positively associated with interest margin (IIoTA),

– negatively associated with cost-income ratio (CIR),

– negatively associated with cost of risk (CoR),

– negatively associated with loans-to-tangible assets (L/TA),

– negatively associated with cost of debt (CoD),

– positively associated with leverage (D/TCE), and

– positively associated with percentage of non-interest income (NonII/OpI) 6

• Hypothesis 5: A bank’s P/TCE is positively associated with the decomposition of g: i.e.,

– negatively associated with payout ratio (PO).

• Hypothesis 6: A bank’s P/TCE is negatively associated with the decomposition of

– negatively associated with dividend yield (DY).

6 With tax considered to be insignificant.

Section 10.2 briefly discussed how an empirical study must be structured to answer the primary research question (What drives the valuation of stocks of G-SIBs compared to stocks of other banks over time?) The approach is based on the cross-sectional relationship between P/TCE and various bank fundamentals derived from accounting concepts This chapter describes how a suitable regression model was devised and the sample data was compiled All variables are developed, leading to the regression formula The dependent variable is P/TCE, explained by the mathematical decomposition of RoE,

CoE, and g, along with the G-SIB designation and some other fundamental bank characteristics The chapter ends by describing the sample characteristics and the regression function.

Regression Framework

The upcoming multivariate regression assumes that the average empirical relationships between financial metrics and firm value are captured in the observed P/TCE values at any given time This model estimates the coefficients of various input factors based on this principle Specifically, it focuses on analyzing the impact of the G-SIB designation, which varies quarterly and affects only certain entities within the sample, namely the G-SIBs This approach is classified as a specialized multivariate regression.

Electronic supplementary material The online version of this chapter (https://doi. org/10.1007/978-3-658-34182-4_11) contains supplementary material, which is available to authorized users.

The article discusses the use of a two-way fixed-effect regression model to analyze the difference-in-difference approach by incorporating binary variables instead of conducting separate regressions It posits that some omitted variables fluctuate over time and across entities, such as G-SIBs and non-G-SIBs, while others remain constant across entities but vary over time, like macroeconomic trends or significant banking events This assumption is crucial for isolating the impact of G-SIBs from other influencing factors on a quarterly basis Consequently, all variables maintain their impact across quarters, with only the G-SIB quarter variable and the time quarter variable subject to change each quarter.

Equation 11.1 summarises the basis relationship:

Dependent Variable: Price-to-Tangible Common Equity (P/TCE)

P/TCE serves as a key valuation metric, representing the ratio of intrinsic equity value to book value Since intrinsic values are not directly observable, market values (P) are utilized, provided that market prices reflect equity efficiently on average without significant deviations tied to fundamentals In such scenarios, these pricing discrepancies manifest in the regression's error term, which is typically normally distributed However, if equity is consistently mispriced, it can lead to biased model coefficients To enhance accuracy, tangible common equity (TCE) is employed as a substitute for simpler book value, ensuring that both the numerator (P) and denominator (TCE) pertain to the same category of equity instruments.

Price, P, refers to the market value of common shares traded on the stock exchange, typically calculated by multiplying the share price by the fully diluted number of outstanding common shares, including those from exercisable options or in-the-money convertibles However, this detailed calculation is generally practical only for small samples Therefore, the standard measure of outstanding shares is utilized, which excludes treasury shares and authorized capital.

Relativebank valuation Various financial metrics+Fixed GSIB time effects+Fixed time effects

For the large sample used in this analysis, the options issue is deemed to be of minor significance 2

The market variable price (P) is equivalent to the accounting variable known as common equity (CE), which represents the total value of all outstanding common shares of a firm This definition specifically excludes additional equity-like components such as preferred equity and various forms of hybrid capital, as well as minority interests not owned by the parent company To accurately determine common equity, these factors must be deducted from the book value of equity.

Intangible assets, such as goodwill, are excluded from common equity to calculate Tangible Common Equity (TCE) for two primary reasons First, including intangibles introduces non-comparable variations, particularly from goodwill recognized in past business combinations Second, investors often assign little value to these subjective assets, especially during economic downturns when earnings are volatile and stable book values are prioritized for valuation This study covers a period that includes at least one recession, highlighting concerns over capital and asset quality, which regulators also emphasize For instance, the Basel III capital regulations focus more rigorously on genuine equity, and the Federal Reserve utilizes TCE as a measure of bank health, making TCE a reliable proxy for regulatory capital.

Figure 7.2 reconciles the accounting and regulatory concepts of how to derive TCE, starting from total equity The formal definition is

Hereafter, the established mathematical explanation and decomposition of P/BV (see Sect 9.3.2) will be amended to reflect the substitution of BV by TCE Adapting

Equation 9.18 results in where RoTCE is the net income attributable to TCE holders over TCE, and CoTCE is the return expectations of TCE holders.

TCE=BV−(intangible assets−goodwill)

−(preferred equity−hybrid capital)−(minority interest)

=total assets−total liabilities−(intangible assets−goodwill)

−(preferred equity−hybrid capital)−(minority interest)

11.2 Dependent Variable: Price-to-Tangible Common Equity (P/TCE)

Explanatory Variables

This study follows a few principles on the inclusion of explanatory variables: 4

• All variables included are commonly used and interpretable;

• Variables are derived from theory as far as possible; and

• The number of variables is restricted to permit sufficient degrees of freedom in estimation.

11.3.1 Return on Tangible Common Equity (RoTCE)

RoTCE is analyzed to enhance the explanatory power of the regression model by transforming individual income statement components into widely recognized ratios The updated Equation 9.20 indicates that the return is calculated based on TCE, where IIoTA represents interest income relative to tangible assets, TA denotes tangible assets, and debt (D) is derived from the difference between TA and TCE Additionally, depreciation and amortization expenses are excluded from this calculation.

Equation 11.4 is then extended to reflect that banks also conduct off-balance-sheet activities, i.e., they do not only grant loans This means that CoR is based more precisely only on gross loans (L) ((LLP/L)×(L/TA) =CoR×L/TA), and non-interest income

(NonII) is added and calculated as ((NonII/OpI)×OpI, with operating income as OpI =II−IE+NonII) This is the common ratio for considering non-interest income

However, it unfortunately leads to circularity, and NonII cannot be perfectly integrated into the above equation since NonII is already included in OpI:

From the decomposition of RoTCE, the following six major key factors have been derived that represent more than the resulting profitability: IIoTA, CIR, CoR, L/TA, CoD, D/TCE,

NonII/OpI and t Figure 3.1 graphically illustrates the decomposition The arrows symbol- ise whether an increasing ratio is considered to be associated with an increasing RoTCE and

RoTCE = ( II − IE − LLP − OE ) × (1 − t )/ TCE

= [ IIoTA × (1 − CIR ) − LLP ] × (1 − t ) + [( IIoTA − CoD ) × (1 − CIR ) − CoR ] × (1 − t ) ×D/TCE

= [IIoTA × (1 − CIR) − LLP] × (1 − t) + [(IIoTA − CoD) × (1 − CIR) − CoR × L/TA] ×(1 − t) × D/TCE + (NonII /OpI) × OpI × (1 − t) × (D/TCE)/D

5 For the income statement items, see Sect 2.2.

4 Cf Cohen (1990), who gives useful guidance with regard to the practical application of regression analysis.

P/TCE Taxes are considered to be insignificant as tax rates are generally the same for all banks within a jurisdiction and cannot be influenced on bank-level.

Business Model ( NonII / OpI ) ( L / TA )

NonII/OpI and L/TA are considered to represent a bank’s overall business model from a

P&L and from a balance sheet perspective, respectively.

Non-interest income (NonII) is a crucial revenue source for banks, typically ranking second after interest income It encompasses fee and commission income from loan products and cross-selling services like insurance Large banks, especially, benefit from trading income through their global investment banking operations These revenue streams are considered off-balance-sheet activities, as they do not rely on long-term interest-bearing assets The NonII to total operating income ratio (NonII/OpI) indicates a bank's dependence on these activities and reflects its business model Due to their asset-light nature, off-balance-sheet activities often yield higher returns on equity compared to traditional on-balance-sheet activities, making P&L margins, particularly the cost-to-income ratio (CIR), a more effective measure of their efficiency.

Fig 11.1 Graphical Illustration of RoTCE Decomposition Source: Similar to Saunders and Cornett (2008, 1)

Off-balance-sheet activities can provide diversification benefits but also tend to exhibit more volatile income streams Consequently, a higher share of these activities is anticipated to enhance valuations, particularly in terms of price-to-tangible common equity (P/TCE) The loans-to-tangible assets ratio (L/TA) indicates the proportion of total assets allocated to gross loans, which are primarily on-balance-sheet activities and typically represent the largest asset class This asset class generates interest income, capturing significant cross-sectional variations in tangible assets (TA) Given the generally lower returns associated with on-balance-sheet activities, it is expected that the L/TA ratio will have a negative correlation with P/TCE.

Net Interest Margin ( IIoTA ) ( CoD )

The net interest margin (NIM) is determined here as ratios representing interest income and interest expense.

Interest income on tangible assets (IIoTA) represents the average yield from all tangible assets, excluding intangible ones When multiplied by the ratio of loans to total assets (L/TA), it reflects the yield on all interest-bearing assets Often termed the gross interest margin, this metric indicates the gross return on the primary asset class of loans and is anticipated to have a positive correlation with bank valuation (P/TCE).

The Cost of Debt (CoD) represents the average interest expenses incurred on all interest-bearing liabilities used to finance loans, indicating how much a bank pays for its funding As a crucial risk metric, CoD reflects the riskiness of a bank's assets, influencing debtors' assessments of the default probability associated with their exposure Consequently, there is an inverse relationship between CoD and Price to Tangible Common Equity (P/TCE).

The cost-income ratio (CIR) measures a bank's operational efficiency by comparing its non-interest expenses to its operating income, excluding loan-loss provisioning This ratio is crucial for assessing a bank's cost efficiency and significantly influences overall profitability Amortisation and impairments of intangibles are not included in this ratio, aligning with the study's focus While recorded intangibles, except goodwill, are amortised according to GAAPs, their impact on the income statement is minimal compared to other expenses, allowing for effective analysis of a bank's financial health.

Asset Quality and Risk ( CoR )

The Cost of Risk (CoR) serves as a key indicator of a bank's risk and asset quality by relating loan-loss provisioning (LLP) to the total gross loans (L) issued LLP can vary significantly over time and is largely discretionary, representing adjustments to loan allowances on the balance sheet rather than actual loan losses As declining asset quality negatively impacts profitability, CoR is anticipated to have an adverse relationship with bank valuation.

The debt-to-tangible common equity (D/TCE) ratio can be interpreted in two ways: it may indicate that higher leverage, resulting in less equity financing, leads to improved capital utilization and potentially higher but more volatile profitability Alternatively, it may suggest that stronger capitalization, characterized by more equity financing, enhances a bank's resilience against charter value loss and provides operational flexibility for loan book growth Additionally, excess capital can signify market power, as banks with greater market presence tend to hold more capital due to higher stakes When emphasizing leverage, the term "leverage ratio" is used, while "capital ratio" is used when focusing on capitalization.

TCE serves as an effective proxy for regulatory capital, with its representation varying based on the intended meaning The mathematical decomposition imposes the representation of (D/TCE), and within a strict theoretical framework that excludes the charter value aspect of banks, it is assumed that (D/TCE) is positively correlated with bank valuation (P/TCE).

Equation 9.23 must be rewritten to reflect the amended equity definition of TCE:

Equation 11.6 represents the dividend yield plus the rate at which the dividend is expected to grow (if CoTCE>g, otherwise P 0 would be infinite or negative) Hence, dividend yield DY is added to the regression variables.

7 Cf Berger (1995, 454–55) and Berger and Bouwman (2013, 146).

8 Cf Keeley (1990) and Goddard, Molyneux, and Wilson (2004).

182 11 Empirical Methodology and Data Substituting CoTCE in Eq 11.3 results in

Dividend Yield (DY) is calculated by dividing paid dividends per share by the current share price, reflecting management's discretion Banks typically provide guidance on DY, aiming to maintain stability for investor planning This metric serves as a forward-looking indicator, embodying the long-term expectations of bank management DY also represents the opportunity costs minus the expected growth rate, suggesting a negative correlation between DY and Price to Tangible Common Equity (P/TCE) Higher long-term expectations make it increasingly challenging for banks to surpass those forecasts.

Estimating growth can be approached in two primary ways: by comparing accounting measures across different historical points, which can be influenced by the selected time frame and bank fundamentals, or by analyzing the reinvestment rate or payout ratio The latter method provides insight into how much a bank is reinvesting for future growth, offering a forward-looking perspective from within the institution.

Adapting Eq 9.17 to TCE and integrating Eq 9.24 results in

Hence, PO is added to the regression variables Substituting g in Eq 11.7 results in

The payout ratio (PO), representing earnings distributed relative to total earnings, can significantly impact bank value and is subject to management influence A higher payout is often linked to a better dividend yield (DY) and a lower price-to-tangible common equity (P/TCE), while also signaling positive bank health, especially during financial distress when other banks may halt shareholder distributions to meet capital requirements Conversely, a low payout, indicating retained earnings, may suggest that a bank anticipates strong future growth opportunities.

Attractive investment opportunities often arise from higher earnings growth, particularly when Return on Equity (RoE) exceeds the Cost of Equity (CoE), leading to increased valuations Although the theoretical implications of Price to Earnings (PO) are unclear, mathematical analysis suggests a negative correlation between PO and Price to Tangible Common Equity (P/TCE).

Sample Data

This empirical study requires two types of micro data for banks:

1 Market data is necessary for share prices, i.e., for the P in the dependent variable.

2 Fundamental data, in particular balance sheet and income statement information, is necessary for all remaining inputs.

The combination of market and accounting measures is not ideal, as accounting measures can be manipulated by banks, while market measures remain fixed This analysis relies on two key assumptions: first, that accounting measures are clearly defined and understood by investors, and second, that these measures accurately reflect the true operations of banks These assumptions are widely accepted in financial research, despite the acknowledgment that accounting data may contain some noise, which is generally considered unbiased Ultimately, market value and dividends, representing actual cash flows to shareholders, depend on distributable profits from an accounting standpoint.

Furthermore, there are two availability requirements with regard to market and fundamental data:

1 Data should be available at least since the first official call of the G20 for appropriate regulation of G-SIBs on 17 November 2008 Data reaching back further would permit a comparison of the pre- and post-FSB regulation eras.

2 Data should be available for (large) banks around the globe and all banks affected by the G-SIB legislation Ideally, all listed global banks should be included to avoid any data selection bias.

Three primary databases meet the criteria for data type and availability: Bankscope, SNL Financial, and Compustat Bank in conjunction with CRSP An overview of their respective strengths and weaknesses is presented in Table 11.1 Over the past few decades, Compustat Bank and CRSP have been favored for academic research, with CRSP established by University of Chicago economists in 1960 and tailored specifically for academic needs Financial bank analysts at central banks also utilize these resources for comprehensive analysis.

Investment banks and data banks are increasingly utilizing SNL Financial, a state-of-the-art database that offers comprehensive financial information Although its historical data is not as extensive as other databases, it is well-suited for the current empirical study, which focuses on large global banks requiring detailed financials within a limited timeframe.

When compiling the required data, several trade-offs exist For the sake of transparency, the following discusses the most relevant decisions made with regard to the data characteristics.

Balanced Data (vs Unbalanced Data)

This analysis employs a two-way fixed-effect regression using a balanced panel data sample, where all variables for each bank are consistently observed during each quarter Balanced panel data offers greater explanatory power, especially in small samples, compared to unbalanced or pooled data However, this approach has a significant drawback, as it necessitates the exclusion of a considerable amount of data when one or more variables are missing in any given observation.

Table 11.1 Overview of Financial Databases for Banks

In this analysis, 187 entities are missing from the sample, but this is not problematic due to the overall large size of the dataset It is assumed that the missing data results from the disclosure practices of specific banks and the random inclusion of banks by the database provider, indicating that the absence of data is not linked to unique errors Additionally, there is no survivor bias present in the balanced panel, as banks that have failed at any point during the study period are included in the overall sample.

Period-End Data of Balance Sheet Items (vs Period Averages)

Balance sheet items reflect values at the end of a period, while income statement items show values accumulated over the entire period For accurate ratio calculations involving both income statement and balance sheet data, it is advisable to use the average balance sheet values for the period Some banks may provide this average data, but commonly, the mean of the current and previous periods is used as an approximation In this analysis, only period-end data is utilized to maintain a consistent sample of Global Systemically Important Banks (G-SIBs), with the potential risk of misrepresenting certain ratios deemed negligible.

Historical Data (vs Forecasted Data)

This study primarily relies on historical data due to its availability, yet the valuation metric P/TCE captures the future return expectations of investors Emphasizing current profitability measures can lead to significant valuation errors, especially in a shifting competitive landscape Research indicates that forward-looking variables offer greater explanatory power than historical financials, with forecasts typically generated by equity research analysts and aggregated by major database providers However, forecasted data presents three key disadvantages: it is limited to the largest listed banks, published irregularly by various analysts, and shows considerable variability in the predicted balance sheet and income statement items.

Multiplying Market Capitalisation with Cumulative Stock Returns (vs Publication Lag of Accounting Data)

Accounting data is generally prepared for each quarter-, half year-, or year-end depending on the respective GAAP, listing requirements, and firm discretion In the

The empirical methodology utilized in this study relies on the assumption that data is typically published within the following quarter, leading to the calculation of P/TCE by multiplying the market capitalization at the end of a quarter with the cumulative stock returns from the subsequent quarter This approach aligns with other academic research in the field, as it accounts for the average delay in accounting data publication Additionally, by focusing on cumulative stock returns rather than actual market capitalizations, this method effectively mitigates the impact of specific events that can influence a bank's total common equity, such as capital increases, share repurchases, or dividend distributions.

All data was downloaded from SNL Financial into Microsoft Excel 2016 (Excel) 23 using SNL’s proprietary Excel add-in SNL Office The sample data was generated in five steps:

1 A list of companies was generated that match the following criteria: (i) industry is bank, savings bank/thrift/mutual, or global investment bank; (ii) listed on a stock exchange; (iii) full coverage level of SNL; (iv) consolidation entity; (v) subsidiaries shown separately when separately listed; (vi) operating company as of now, i.e not acquired or defunct; and (vii) all geographies.

2 The data for the above filtered financial institutions was downloaded with the following attributes: (i) quarterly data from Q1 2008 until Q2 2015 for accounting information and from Q2 2008 until Q3 2015 for market information; (ii) as originally reported, i.e no restated data; (iii) reported in euros or converted into euros (balance sheet data was converted as of the date of the end of the period, and income statement data was converted using the average exchange rate over the period) 24 The analysis does not go back earlier than Q1 2008 because accounting information on G-SIB is increasingly limited for earlier years (see Table 11.2).

3 The panel data was organised in the form of unstacked data, i.e only one case (row) per bank and quarter Market data, i.e price P, was matched with accounting data This resulted in about 60,000 cases.

4 If possible, missing data for G-SIBs was complemented manually to increase sub- sample size, which is crucial for the analysis given the small G-SIB sample size For this purpose, individual balance sheet data items of G-SIBs were assumed to be constant for up to 4 quarters, if deemed appropriate and not disclosed otherwise This proceeding is considered unbiased as investors would make the same approximating assumption if no financial data was published.

22 Cf Calomiris and Nissim (2007) and Calomiris and Nissim (2014) who use 75 days.

23 Only the 64-bit program version is capable of handling the large amount of data.

5 The data was solely edited in Excel to calculate ratios and insert dummy variables for the regression Subsequently, cases with incomplete data were removed resulting in about 27,000 cases The dependent variable, P/TCE, was then truncated at the one percent level, and all explanatory variables were winsorised at the one percent level Table A.1 in the electronic supplementary material provides a detailed explanation of how the variables were sourced and calculated.

Sample Characteristics

The analyses were performed using IBM SPSS Statistics 23, highlighting distinctions between the full sample, G-SIB, and non-G-SIB banks The study examines the sample's constituents, bank fundamentals, and statistical characteristics, noting that average and median results should be interpreted cautiously due to varying bank participation each quarter and significant changes in the business environment during the analysis period The data indicates that G-SIBs and non-G-SIBs exhibit different financial characteristics, likely stemming from their unique business models and size Additionally, while there are statistically significant differences between large and small banks, these differences are relatively minor Consequently, this study focuses on the full sample of banks with complete data sets available.

Table 11.2 outlines the regional characteristics of a balanced sample comprising 27,071 data sets, with 357 linked to Global Systemically Important Banks (G-SIBs) The majority of these banks are based in the United States and Canada, while Latin America and the Caribbean have a minimal representation, with no G-SIBs located in that region.

Table 11.2 Sample Characteristics by Region

Loudis and Allahrakha (2016) highlight that borderline non-G-SIBs exhibit similarities to G-SIBs regarding certain indicators of systemic importance, yet they also show significant differences in other aspects.

Tiêu đề	Too-Big-to-Fail in Banking Impact of G-SIB Designation and Regulation on Relative Equity Valuations
Tác giả	Tom Filip Lesche
Người hướng dẫn	Anna Pietras
Trường học	Witten/Herdecke University
Thể loại	thesis
Năm xuất bản	2021
Thành phố	Witten

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Số trang	256
Dung lượng	6,53 MB