Structural Corporate Degradation Due to Too-Big-To-Fail Finance

In Structural Corporate Degradation Due to Too-Big-to-Fail Finance, I examined how and why financial conglomerates that have grown too large to be efficient find themselves free from the standard and internal and external corporate structural pressures push to resize the firm. The too-big-to-fail funding boost—from lower financing costs because lenders know that the government is unlikely to let the biggest financial firms fail—shields the financial firm’s management from restructuring pressures. The boost’s shielding properties operate similar to “poison pills” for industrial firms, in shielding managers and boards from restructurings. But unlike the conventional pill, the impact of the too-big-to-fail funding boost reduces the incentives of insiders to restructure the firm, not just outsiders. These weakened restructuring incentives weaken both the largest financial firms and the financial system overall, making it more susceptible to crises. The article predicts that if and when too-big-to-fail subsidies diminish, the largest financial firms will face strong pressures to restructure.

For industrial conglomerates that have grown too large, internal and external corporate structural pressures push to re-size the firm. External activists press it to restructure to raise its stock market value. Inside the firm, boards and managers see that the too-big firm can be more efficient and more profitable if restructured via spin-offs and sales. But for large, too-big-to-fail financial firms (1) if the value captured by being too-big-to-fail lowers the firms’ financing costs enough and (2) if a resized firm or the spun-off entities would lose that funding benefit, then a major constraint on industrial firm over-expansion breaks down for too-big-to-fail finance.

Propositions (1) and (2) have both been true and, consequently, a major retardant to industrial firm over-expansion has been missing in the large financial firm. Debt cost savings from the implicit subsidy can amount to a good fraction of the big firms’ profits. Directors contemplating spin-offs at a too-big-to-fail financial firm accordingly face the problem that the spun-off, smaller firms would lose access to cheaper too-big-to-fail funding. Hence, they will be relatively more reluctant to push for break-up, for spin-offs, or for slowing expansion. They would get a better managed group of financial firms if their restructuring succeeded, but would lose the too-big-to-fail subsidy embedded in any lowered funding costs. Subtly but pervasively, internal corporate counterpressures that resist excessive bulk, size, and growth degrade. It’s not just that some firms are too-big-to-fail, some are too-big-to-manage, and some are both, but that the two characteristics link together, with any implicit too-big-to-fail subsidy pushing firms to be too-big-to-manage.

The resulting corporate degradation burdens the economy. In addition to the well-known costs of bailouts and economic contraction if major financial firms fail, too-big-to-fail finance degrades financial firm efficiency. The mechanism identified here has policy implications beyond adding to the reasons to reduce too-big-to-fail risks. Most post-crisis financial regulation has been command-and-control rules on capital and activities, but the analytic here points us to unused incentives-based policy tools. Lastly, the corporate degradation analytic has on-the-ground corporate dealmaking implications: if the command-and-control regulation moving forward is succeeding, it should lead to sharp corporate restructurings in financial firms if large financial firms lose their too-big-to-fail boost. I outline the mechanisms and implications.

The full paper is available for download here.