That is not my pessimistic verdict; it is the market’s. Prior to the crisis, the 29 largest global banks benefited from just over one notch of uplift from the ratings agencies due to expectations of state support. Today, those same global leviathans benefit from around three notches of implied support. Expectations of state support have risen threefold since the crisis began.
This translates into a large implicit subsidy to the world’s biggest banks in the form of lower funding costs and higher profits. Prior to the crisis, this amounted to tens of billions of dollars each year. Today, it is hundreds of billions. In other words, if the market’s expectations are to be believed, the regulatory response to the crisis has not plugged the ‘too-big-to-fail’ sink.
On the face of it, that sounds perplexing. Rarely a day passes without a warning from the financial industry about overbearing regulation of, in particular, the world’s biggest banks. What is certainly true is that, in the light of the crisis, regulation to quell the too-big-to-fail problem has come thick and (at least in regulatory terms) fast. This reform effort falls into roughly three categories:
(a) Systemic surcharges: Of additional capital levied on the world’s largest banks according to their size and connectivity. This Pigouvian tax on systemic risk externalities is built on conceptually sound foundations. And, encouragingly, good economics has found its way into good public policy. Last year, the Financial Stability Board (FSB) agreed a sliding scale of systemic surcharges for the world’s largest banks. The highest surcharge was set at 2.5% of capital. Yet therein lies the problem. Based on my estimates, a charge levied at this rate would leave the majority of the systemic externalities associated with the world’s biggest banks untouched. The reduction in default probabilities associated with lowering leverage by a percentage point or two would not offset the higher system-wide loss-given-default associated with the world’s largest banks. The systemic tax is being levied at rates which are too low to meet Pigouvian ends.
(b) Resolution regimes: In principle, orderly resolution regimes for banks could lower the collateral costs of a big