As the Great Recession has shown some banks became too-big-to-fail. What does it mean? In the event of another financial crisis, a failure of such a bank would cause a major disruption in the world economy. So it is clear that such banks will not be allowed to fail. They will be saved by governments to prevent another meltdown of the world economy, as happened when Lehman Brothers failed.
The problem is that, the knowledge that a bank will be bailed out if it runs into problems will encourage bank management to take on excessive risk. In addition, it will reduce the bank's cost of funds, giving it an advantage over smaller banks. This would lead to a consolidation of the banking system, which is not desirable.
The solution: systematically important banks (30 banks around the world, none Canadian), will have to have more capital than smaller banks.
This accomplishes two things:
- it lowers the risk of bank failure
- it increases the cost of doing business for big banks, offsetting their lower cost of funds
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