Does Size Matter? Bailouts with Large and Small Banks

54 Pages Posted: 26 Dec 2017

See all articles by Eduardo Davila

Eduardo Davila

Yale University - Department of Economics; National Bureau of Economic Research (NBER)

Ansgar Walther

Imperial College London; Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 2 versions of this paper

Date Written: December 19, 2017

Abstract

We explore how large and small banks make funding decisions when the government provides system-wide bailouts to the financial sector. We show that bank size, purely on strategic grounds, is a key determinant of banks’ leverage choices, even when bailout policies treat large and small banks symmetrically. Large banks always take on more leverage than small banks because they internalize that their decisions directly affect the government’s optimal bailout policy. In equilibrium, small banks also choose strictly higher borrowing when large banks are present, since banks’ leverage choices are strategic complements. Overall, the presence of large banks increases aggregate leverage and the magnitude of bailouts. The optimal ex-ante regulation features size-dependent policies that disproportionally restrict the leverage choices of large banks. A quantitative assessment of our model implies that an increase in the share of assets held by the five largest banks from 50% to 70% is associated with a 3.5 percentage point increase in aggregate debt-to-asset ratios (from 90.1% to 93.6%). Under the optimal policy, large banks face a “size tax” of 40 basis points (0.4%) per dollar of debt issued.

Keywords: bailouts, bank regulation, too-big-to-fail, too-many-to-fail, size tax

JEL Classification: G21, G28, E61

Suggested Citation

Davila, Eduardo and Walther, Ansgar, Does Size Matter? Bailouts with Large and Small Banks (December 19, 2017). Available at SSRN: https://ssrn.com/abstract=3090754 or http://dx.doi.org/10.2139/ssrn.3090754

Eduardo Davila (Contact Author)

Yale University - Department of Economics ( email )

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National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
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Ansgar Walther

Imperial College London ( email )

South Kensington Campus
Exhibition Road
London, Greater London SW7 2AZ
United Kingdom

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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