Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Breaking up the ‘too-big-to-fail’ banks

Banks suffer from substantial moral hazard problems: they have incentives to take excessive risk, safe in the knowledge that if things get sticky Mr and Ms taxpayer will save the day (check out Chapter 15 for all about moral hazard). Governments feel obliged to come to the aid of a failing bank, because allowing it to fail will have a bad impact on all other financial institutions, possibly leading to a cascade of failures (as we discuss in Chapter 14).

Generally, the larger the bank, the worse the impact of its failure is on everyone else. One idea is that any bank that’s ‘too big to fail’ (so big and the impact of its failure so catastrophic that governments will always bail it out if it gets into difficult) is really just too big to exist.

Advocates suggest breaking up large banks into small parts so that none of them is too big to fail. They present two, linked, advantages that will result from doing so:

Taxpayers are no longer on the hook for the bad decisions of bankers.


Banks take less risk, because they know that they really will be allowed to fail if they mess up.

Thus if a government announces that it will no longer bail out a failing financial institution, people take the threat seriously. In other words, it’s now a credible threat as opposed to an incredible one (that banks treat as a bluff, see Chapter 15).

In reality no jurisdictions have seriously tried to break banks up into small pieces. Instead they’ve attempted to ‘ring fence’ a bank’s high-street operations from its more risky investment banking operations. The idea is that if the investment banking arm of a bank makes a bad call, the ordinary depositor is protected.

The reality is, in today’s globalised world it is difficult to regulate large financial institutions because they can relocate to somewhere else if the regulation is seen as too tough. In that context, ring fencing might not be a bad compromise.