“Big bank, small bank, I like to make money,” said Jared Vennett, Ryan Gosling’s character in the 2015 film The Big Short. Though Vennett’s indifference makes sense for a profit-seeking homo economicus, the size of financial institutions, particularly when they fail or require government assistance to prevent failure, matters a great deal.
A new paper from the Federal Reserve examines the effects that failure of or financial stress on banks of different sizes have on economic growth writ large:
We examine whether financial stress at larger banks has a different impact on the real economy than financial stress at smaller banks. Our empirical results show that stress experienced by banks in the top 1 percent of the size distribution leads to a statistically significant and negative impact on the real economy. This impact increases with the size of the bank. The negative impact on quarterly real GDP growth caused by stress at banks in the top 0.15 percent of the size distribution is more than twice as large as the impact caused by stress at banks in the top 0.75 percent, and more than three times as large as the impact caused by stress at banks in the top 1 percent. These results are broadly informative as to how the stringency of regulatory standards should vary with bank size, and support the idea that the largest banks should be subject to the most stringent requirements while smaller banks should be subject to successively less stringent requirements.
Further confirming the influence of large-bank failure on economic performance more broadly, the results for both unemployment and GDP growth are statistically significant (measured at the generally-accepted 5 percent threshold) only for the top 1 percent of banks. Whether these effects of stress in that top echelon of banks are economically significant is a distinct question — but the paper finds that here, too, the answer is yes.
What are the costs of failure among these large institutions? The authors find “that the failure of a single bank —above the 99.5th size percentile … would result in (an) approximately 42 percent decline in quarterly real GDP growth, while failures of five banks … above the 99th size percentile would result in approximately a 14 percent decline in quarterly real GDP growth.” The authors found similar results for unemployment.
These findings don’t necessarily imply that the size of a financial institution per se is the problem. The complexity and interconnectedness of a bank’s investments matter more than the size of the balance sheet, and even more important is how leveraged a given institution is (i.e., how much they finance with equity vs. debt.)
So, while the failure of larger financial institutions has outsized negative effects on economic growth, making them safer through higher capital requirements should be the first move, not calling to break them up.