is whether, in practice, the ring-fence could prove permeable. Without care, today’s ring-fence could become tomorrow’s string vest.
If each of these initiatives is necessary but none is individually or collectively sufficient to tackle too-big-to-fail, what is to be done? One solution might lie in strengthening these proposals. For example, re-sizing the capital surcharge, perhaps in line with quantitative estimates of the ‘optimal’ capital ratio, would be one option for bearing down further on systemic externalities.
Another more radical option, mooted recently by a number of commentators and policymakers, would be to place size limits on banks, either in relation to the financial system as a whole or, more coherently, relative to GDP. Proposals of this type typically face two sets of criticism.
The first, practical issue is how to calibrate an appropriate limit. Recent research on the link between and financial depth and growth provides a way into this question. This research has suggested that there is a threshold at which the private-credit-to-GDP ratio may begin to have a negative impact on GDP and, in particular, productivity growth. By taking a view on this aggregate threshold, and on an appropriate degree of concentration within the financial system, an institution-specific threshold could be derived.
The second, empirical issue is whether size limits would erode the economies of scale and scope which might otherwise be associated with big banks. The empirical literature on these economies has, until recently, suggested they may be exhausted at relatively low balance sheet thresholds. But a number of recent papers have painted a more optimistic picture, with economies of scale found for banks with balance sheets in excess of $1 trillion.
Yet this evidence needs to be interpreted cautiously, not least because it fails to recognise the implicit subsidies associated with too-big-to-fail. These would tend to lower funding costs and boost measured valued-added for the big banks. In other words, the implicit subsidy would show up as economies of scale. Bank of England research has recently shown that, once those subsidies are accounted for, evidence of scale economies for banks with assets in excess of $100 billion tends to disappear. Indeed,