Bank Risk of Failure and the Too-Big-To-Fail Policy

Abstract

Some U.S. banks may be perceived as too big to fail: If any such bank were to get into trouble, the market may expect a government bailout. In general, the possibility of contingent bailouts creates a risk and a size distortion in the decisions of banks. As a result, banks tend to become riskier and larger. The cost of the too-big-to-fail distortions could be high, but the available evidence about their importance in the U.S. economy is inconclusive. In particular, the evidence provided by Boyd and Gertler (1994) for the period 1983-1991 has become much weaker in recent years. Any proposal for policy reform should weigh these empirical limitations: With the available data it is very difficult to judge the significance of the too-big-to-fail problem.