‘Too Systemically Important to Fail’ in Banking

The recent financial turmoil and bailouts of a large number of banks have raised substantial policy concerns regarding banks that are considered ‘Too-systemically important-to-fail' (TSITF). In this paper, we exploit a sample of bank mergers and acquisitions (M&As) between 1997 and 2008 in nine EU economies and use an innovative setup derived from the frontier literature to capture safety net subsidy effects and evaluate their ramifications for systemic risk. We focus on three closely related phenomena: First, we use frontier methods to extract information on whether banks deliberately pay premiums for being considered TSITF. Second, we incorporate the safety net subsidies derived from the frontier methods in a probit model to assess whether they affect the probability of a bank being rescued during the recent crisis. We find that safety net benefits derived from M&A activity have a significantly positive association with the rescue probability, suggesting the moral hazard issue in banking systems pre-crisis. Third, we do not find that gaining safety net subsidies leads to TSITF bank's increased interdependence on its peer banks. From a policy perspective, the findings help understand whether banks exploit national safety nets and increase instability in the financial system