Abstract
We analyze the link between “too big to fail” (TBTF) and moral hazard using a natural experiment from an epoch of unregulated commercial banking in Denmark. In 1908 the country faced a large banking shock where the creditors of distressed commercial banks received a bailout by the government for the first time in Danish history. Due to a fortuitous combination of circumstances, banks continued to operate in an unregulated environment for more than a decade after the bailout. By considering a sample from a pre-regulation epoch, we isolate the TBTF effect. Our empirical analysis shows that TBTF banks significantly reduced post-bailout capital ratios compared to other banks.
This is a preview of subscription content, log in via an institution to check access.
Similar content being viewed by others
Notes
When Bear Stearns was bailed out in March of 2008, it created a moral hazard situation in which the incentive for troubled financial institutions to deal with their problems weakened. When Lehman Brothers sought government assistance six month later, the market expected help to be forthcoming. Help was refused, however, and Lehman filed for bankruptcy. The ensuing chaos in financial markets changed the stance of the U.S. government. Going forward, when systemic financial institutions asked for help, the government would rescue them (Hoshi 2011). See also Roman (2019) for a survey of the literature on recent bailouts.
The term “too big to fail” was coined by U.S. Congressman Stewart McKinney in reference to the rescue of Continental Illinois in 1984 (Gorton and Tallman 2016).
TBTF is essentially a credibility problem (Gorton 2012; Strahan 2013). Policymakers weaken market discipline ex ante because they prefer bailing out TBTF banks ex post. Policymakers with career concerns may prefer bailout ex post even if the long-term societal costs of moral hazard exceed the short-run benefits from the avoidance of further market panic.
Because financial institutions invest in financial assets that will be used to pay for the investment projects of nonfinancial companies, TBTF distorts the allocation of resources in the broader economy (Strahan 2013).
The argument presupposes that holders of bank equity are less likely to be bailed out than depositors and other creditors, which has been the case historically (Strahan 2013).
Gorton and Tallman (2016), however, question that large banks become riskier as a result of implicit TBTF guarantees. They cite evidence that more concentrated banking systems are less likely to experience financial crises (Beck et al. 2006) and that bank CDS spreads are not more sensitive to size than those of nonfinancial firms (Ahmed et al. 2015). Using the case of the French crisis of 1889, which involved a run on Comptoir d’Escompte, one of the largest banks in France, Hautcoeur et al. (2014) argue that a bailout of an insolvent TBTF bank need not engender moral hazard if designed properly.
Internationally, the three earliest bank rescues on record are 1826, 1838, and 1848 in Australia, Belgium, and Prussia (Grossman 2010).
The international historical evidence shows that substantial regulatory changes typically followed in the aftermath of banking crises (Grossman 2010).
Privatbanken, Landmandsbanken, and Handelsbanken were founded in, respectively, 1857, 1871, and 1873.
Trade barriers abroad and uncertainty about the wording of a customs law that was being negotiated meant that many investors preferred bank shares over the shares of industrial firms (Cohn 1957).
The insurance value of buildings in Copenhagen almost tripled from 1901 to 1908 (Cohn 1957).
See Durdu et al. (2020) for systematic evidence on the role of U.S. monetary policy in banking crises across the world since 1870.
Privatbanken in return was granted full control over Centralbanken (Green 1910).
In the memorable words of Thalbitzer (1909, p. 146), the committee morphed into a “welfare committee” for the banking sector.
The worry about domino and contagion effects drove the bailout. It ended up costing 17 million Danish kroner, which was about 10% of GDP in 1908 (Østrup 2008).
This is also the view of Emil Meyer, permanent undersecretary of Nationalbanken in 1908 and later its governor (Thalbitzer 1909, p. 155).
Economists of the early twentieth century were not unfamiliar with the idea of moral hazard. As early as 1838, for example, when Bank de Belgique was rescued, the Belgian government was warned by a commission of inquiry that such a rescue would engender moral hazard going forward (Grossman 2010).
This echoes the so-called Austrian view of how to most efficiently manage a banking panic, which holds that the panic should simply be allowed to run its course (Aliber and Kindleberger 2015).
For an empirical analysis of the Savings Bank Act of 1880, see Abildgren (2019).
Liberal economic ideas were being challenged throughout the West in the late nineteenth century. Yet the emphasis on free economic and financial agents remained dominant. The financier was the overseer of the market economy, and he made entrepreneurship possible by financing innovation and carrying the associated risks (Hansen 2012).
For a comprehensive survey of the Danish banking system from 1850 to 1920, see Hansen (1991).
This number is roughly constant throughout the post-bailout period 1909–1920. Moreover, of these 60% of all assets, Landmandsbanken, Privatbanken, Handelsbanken, and Laane- og Diskontobanken accounted for 44, 24, 23, and 9%.
That is, \({\textit{TBTF}} = 1\) if bank i \(\in\) {Landmandsbanken, Privatbanken, Handelsbanken, Laane- og Diskontobanken}, zero otherwise.
Parallel does not mean linear. The time fixed effects allow for flexible time trends that move up and down over the years (Wing et al. 2018).
There had been minor banking crises in 1857–1858, 1876–1878 and 1885, but they were all liquidity crises (Hansen 1997).
Atanasov and Black (2016) call this the “only-through condition.”
If a banking act impacts all banks in the same way, it is picked up by the time fixed effects, \(\mu _{t}\).
Note that the panel is unbalanced. In a balanced panel, we obtain similar results. Re-estimating column 3 of Table 1 gives a coefficient value of \(-0.0245\) (\(\mathrm{s.e.}= 0.008\)).
Denmark also suspended gold convertibility of the krone on 2 August 1914 (Sørensen 2014).
The data are taken from tabulated balance sheets for commercial banks published by the so-called financial department for the period 1890 to 1911. The publication was named “Summary of the information provided by the note-issuing and commercial banks to the financial department” (our translation). The task of compiling these balance sheets was taken over by the Bank Inspection from 1912. We focus on commercial banks as these are the ones most comparable to the Danish ones. From this period, the publication changed title to “Information about the banks.” In Swedish the title is: “Sammandrag af de enskilda sedelutgifvande bankernas och aktiebankernas till Kongl. Finansdepartementet ingifna uppgifter” for the older publications and “Uppgifter om bankerne” for the later years. The reports can be downloaded from webpage of Statistics Sweden at https://www.scb.se/hitta-statistik/sok/?Query=bank&Tab=older.
That is, \({\textit{TBTF}} = 1\) if bank i is one of the four Danish TBTF banks or one of the largest Swedish banks; it is zero else.
Note that Eq. (3) has country-specific year fixed effects. They will likely pick up the effects of the Banking Act of 1897, effective as of 1903, which revoked note issue for so-called Enskilda banks. (These note-issuing banks are not included in our sample.) The law also operated with two different levels of capital requirements, where banks with smaller businesses were required to hold less capital. In a revision of the banking legislation in 1911 the minimum capital requirements for small banks were raised. Moreover, the revision stipulated stricter minimum reserve requirements; and if banks held six times the capital requirement, they were allowed to trade with shares (Grossman 2010; Ögren 2011).
When banks fail, information capital is lost. As a result, many firms will not have access to funds to pursue productive investments. If a panic occurs and many banks fail, the economy’s ability to allocate capital is severely hampered. This happened in the U.S. in the early 1930s, where the Great Depression was (partly) triggered by waves of bank failures (Bernanke 1983).
Yet this is a worthy research question. “In the long term, it is important to assess if meeting the short-term goals of bailouts [stabilizing financial markets] may have resulted in unintended consequences [incentive distortions] that can linger for a long time” (Roman 2019, p. 634).
References
Abildgren, K. 2016. Determinants of banks’ capital structure in the pre-regulation era. European Review of Economic History 21 (1): 64–82.
Abildgren, K. 2018. A collection of Danish historical micro data. https://sites.google.com/view/kim-abildgren/historical-statistics.
Abildgren, K. 2019. Banking regulation-burden or blessing? Journal of Financial Economic Policy 11 (4): 548–562.
Admati, A., and M. Hellwig. 2014. The bankers’ new clothes: what’s wrong with banking and what to do about it-updated edition. Princeton: Princeton University Press.
Ahmed, J., C. Anderson, and R. Zarutskie. 2015. Are the borrowing costs of large financial firms unusual? FEDS Working Paper.
Aliber, R.Z., and C.P. Kindleberger. 2015. Manias, panics, and crashes: a history of financial crises. Berlin: Springer.
Allen, F., E. Carletti, I. Goldstein, and A. Leonello. 2015. Moral hazard and government guarantees in the banking industry. Journal of Financial Regulation 1 (1): 30–50.
Angrist, J.D., and J.-S. Pischke. 2009. Mostly harmless econometrics: an empiricist’s companion. Princeton: Princeton University Press.
Atanasov, V.A., and B.S. Black. 2016. Shock-based causal inference in corporate finance and accounting research. Critical Finance Review 5: 207–304.
Avery, R.B., T.M. Belton, and M.A. Goldberg. 1988. Market discipline in regulating bank risk: new evidence from the capital markets. Journal of Money, Credit and Banking 20 (4): 597–610.
Beck, T., A. Demirgüç-Kunt, and R. Levine. 2006. Bank concentration, competition, and crises: first results. Journal of Banking & Finance 30 (5): 1581–1603.
Berger, A.N., R.J. Herring, and G.P. Szegö. 1995. The role of capital in financial institutions. Journal of Banking & Finance 19 (3–4): 393–430.
Bernanke, B.S. 1983. Nonmonetary effects of the financial crisis in the propagation of the great depression. American Economic Review 73 (3): 257–276.
Casse, P. 1909. Hvilke Farer rummer vor økonomiske situation? Nationaløkonomisk Tidsskrift 17 (1): 317–371.
Cohn, E. 1957. Privatbanken i Kjøbenhavn gennem hundrede Aar 1857–1957: Efter Aarhundredskiftet.¿ 2-2. halvbind. Privatbanken i Kjøbenhavn.
Demsetz, R.S., and P.E. Strahan. 1997. Diversification, size, and risk at bank holding companies. Journal of Money, Credit, and Banking, 300–313.
DST 1969. Kreditmarkedsstatistik: Statistiske Undersøgelser Nr. 24
Durdu, C.B., A. Martin, and I. Zer. 2020. The role of US monetary policy in banking crises across the world. IMF Economic Review 68 (1): 66–107.
Gorton, G. 2012. Misunderstanding financial crises: why we don’t see them coming. Oxford: Oxford University Press.
Gorton, G., and E.W. Tallman. 2016. Too big to fail before the fed. American Economic Review 106 (5): 528–32.
Green, H. 1910. Bankrisen II. Greens danske fonds og aktier.
Grossman, R.S. 2010. Unsettled account: the evolution of banking in the industrialized world since 1800, vol. 33. Princeton: Princeton University Press.
Hannan, T.H., and G.A. Hanweck. 1988. Bank insolvency risk and the market for large certificates of deposit. Journal of Money, Credit and Banking 20 (2): 203–211.
Hansen, P.H. 1991. From growth to crisis: the Danish banking system from 1850 to the interwar years. Scandinavian Economic History Review 39 (3): 20–40.
Hansen, P.H. 1997. Bankredninger i Danmark-en stabil tradition. In Den danske banksektor-mellem tradition og forandring, ed. T. Andersen and K. Ronit, 37–76. Århus: Systime.
Hansen, P.H. 2001. Bank regulation in Denmark from 1880 to World War Two: public interests and private interests. Business History 43 (1): 43–68.
Hansen, P.H. 2010. Finansielle krisers efterspil i (Danmarks)historien, 1857–1930. Samfundsøkonomen 1: 23–28.
Hansen, P.H. 2012. Making sense of financial crisis and scandal: a Danish bank failure in the first era of finance capitalism. Enterprise & Society 13 (3): 672–706.
Hansen, P.H., and S. Mørch. 1997. Den Danske Bank. Centrum.
Hansen, S.A., and I. Henriksen. 1980. Sociale Brydninger 1914–39. Gyldendal.
Hautcoeur, P.-C., A. Riva, and E.N. White. 2014. Floating a “lifeboat": the Banque de France and the crisis of 1889. Journal of Monetary Economics 65: 104–119.
Hoshi, T. 2011. Financial regulation: lessons from the recent financial crises. Journal of Economic Literature 49 (1): 120–28.
Kroszner, R. 2016. A review of bank funding cost differentials. Journal of Financial Services Research 49 (2–3): 151–174.
Mishkin, F.S. 2006. How big a problem is too big to fail? A review of Gary Stern and Ron Feldman’s too big to fail: the hazards of bank bailouts. Journal of Economic Literature 44 (4): 988–1004.
Moe, J. 1955. Bankloven og banklovforslaget. Nationaløkonomisk Tidsskrift 93 (1): 14–33.
Mørch, S., and K.R. Olsen. 1986. Det store bankkrak: Landmandsbankens sammenbrud 1922–1923. Gyldendal.
Ögren, A. 2011. The causes and consequences of banking regulation: the case of Sweden
O’hara, M., and W. Shaw. 1990. Deposit insurance and wealth effects: the value of being “Too Big to Fail”. Journal of Finance 45 (5): 1587–1600.
Østrup, F. 2008. Finansielle kriser. Karnov Group.
Rime, B. 2005. Do too-big-to-fail expectations boost large banks issuer ratings. Swiss national banks, systemic stability section: working paper (May 9).
Roman, R.A. 2019. bank bailouts and bail-ins. In The Oxford handbook of banking.
Rubow, A. 1920. Nationalbakens historie: 1878–1908, vol. 2. I kommission hos Gyldendal.
Sørensen, N.A. 2014. Denmark.
Stern, G.H., and R.J. Feldman. 2004. Too big to fail: the hazards of bank bailouts. Brookings Institution Press.
Strahan, P.E. 2013. Too big to fail: causes, consequences, and policy responses. Annual Review of Financial Economics 5 (1): 43–61.
Svendsen, K.E., S.A. Hansen, E. Olsen, and E. Hoffmeyer. 1968. Dansk pengehistorie 1700–1960. Danmarks Nationalbank.
Thalbitzer, C. 1909. Danske Bankforhold i 1908. Foredrag i Nationaløkonomisk Forening den 4. Februar 1909. Nationaløkonomisk Tidsskrift 17 (2): 129–156.
Wing, C., K. Simon, and R.A. Bello-Gomez. 2018. Designing difference in difference studies: best practices for public health policy research. Annual Review of Public Health 39: 453–469.
Wooldridge, J.M. 2010. Econometric analysis of cross section and panel data, 2e. Cambridge: MIT Press.
Author information
Authors and Affiliations
Corresponding author
Additional information
Publisher's Note
Springer Nature remains neutral with regard to jurisdictional claims in published maps and institutional affiliations.
We would like to thank the co-editor, two anonymous referees, Lasse Aaskoven, Kim Abildgren, Christian Bjørnskov, Richard Grossman, Per H Hansen, Ralf Meisenzahl, Alexander Schandlbauer, participants at the 2020 Danish Public Choice Workshop, the EEA Virtual Congress 2020, and the 6th Annual Meeting of the Danish Society for Economics and Social History 2020 for helpful comments. On behalf of all authors, the corresponding author states that there is no conflict of interest.
Rights and permissions
About this article
Cite this article
Andersen, T.B., Jensen, P.S. Too Big to Fail and Moral Hazard: Evidence from an Epoch of Unregulated Commercial Banking. IMF Econ Rev 70, 808–830 (2022). https://doi.org/10.1057/s41308-022-00167-7
Published:
Issue Date:
DOI: https://doi.org/10.1057/s41308-022-00167-7