Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Markets that are Too Big To Fail (TBTF)

We hear a lot about TBTF banks, but I think in the post crisis world, policy makers are beginning to view some markets as being TBTF. The IMF published a working paper last month by Darryl King et al. on Central Bank Emergency Support to Securities Markets. This paper appears to me to formalize and legitimize this idea. My unease about this paper is that it not only endorse almost everything that the central banks did during the crisis, but also elevates these to the level of best practices. The paper ignores the fact that while these might have helped in the crisis, they would also have unintended effects on the functioning of markets during normal times.

Markets that are highly likely to be bailed out during a future crisis will be perceived as safer even during normal times. Bonds that trade in these markets will therefore command lower yields. The result is a subsidy to the borrowers issuing these bonds. The subsidy to TBTF banks is partially alleviated through more stringent regulation of these banks (SIFIs), but there is no such regulatory pressure on corporate borrowers benefiting from the subsidization of TBTF markets.

I am fond of Kindleberger’s statement that a lender of last resort must exist but his existence should be doubted. In their eagerness to legitimize whatever was done during the crisis, policy makers are removing this doubt and making the TBTF subsidy more certain and more significant. They are picking winners and losers, and since the winners that they choose are the mature companies, they are penalizing the more innovative dynamic firms that are crucial for long term economic growth.

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