Traditional approaches to bank regulation may not be adequate for large banks, which can be more fragile than smaller banks, and pose greater systemic risks, according to a new paper from the International Monetary Fund (IMF).
The IMF released a discussion note Wednesday that examines the phenomenon of large banks, and their contribution to systemic risk. It finds that large banks tend to have lower capital, less-stable funding, that they engage in more market-based activities that go beyond traditional banking, and that they are more organizationally complex than small banks. “This suggests that large banks may have a distinct, possibly more fragile, business model,” it concludes.
In particular, the paper says that when large banks have lower capital levels and less-stable funding, they are are riskier, and they create more systemic risk. They also create more systemic risk, but are not individually riskier, when they engage more in market-based activities, or are more organizationally complex, it says.
The failure of a large bank also tends to be more disruptive to the financial system than failures of small banks, the paper says. When a large bank fails, it generates liquidity stress in the banking system; their functions that rely on economies of scale and scope cannot easily be replaced by small banks; and the marginal cost of taxpayer support may increase, it suggests.
As a result, the paper concludes that traditional bank regulation, which focuses on individual bank risk, may not be sufficient for large banks. “Additional regulation, based on systemic risk considerations, is needed to deal with the externalities of distress of large banks,” it says, including capital surcharges, and regulatory measures to reduce their involvement in market-based activities, and to curb their organizational complexity.
While banks may get too big from a social welfare perspective, the report also says that there are gains to economies of scale, and so, it’s not clear that there is an “optimal” size for banks.