Tuesday, 31 March 2009

Bigger is worse

There is a meme going around at the moment concerning size in banking. The basic idea is that too big to fail banks are a bad idea. Various people have various ideas of what 'too big' is, with numbers like 300B total assets (a number floated in a nice post at Dealbreaker) being discussed. Interfluidity also has a good discussion here.

My own take is that limits - whether $100B, $300B or some other number - are hard to impose and liable to manipulation, e.g. through off B/S financing. Rather I would make regulatory capital a function of equity. The more Tier 1 you have, the less you can leverage it. At $1B of Tier 1 or below, say, you are allowed a Tier 1 leverage ratio of 25. At $17B, it would be 12, so the formula would be something like

permitted leverage = 20 - 0.5 x [max($1B, Tier 1) - $1B]
total permitted assets = permitted leverage x Tier 1

This formula has a maximum at Tier 1 = $20B, where it permits total assets of $200B (and of course total assets would be defined to include off B/S assets as well as on B/S ones).

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