When bigger isn’t better: bailouts and bank behaviour

Lending retail deposits to SMEs and household borrowers may be the traditional role of commercial banks: but banking in Britain has been transformed by increasing consolidation and by the lure of high returns available from wholesale Investment activities. With appropriate changes to the baseline model of commercial banking in Allen and Gale (2007), we show how market power enables banks to collect „seigniorage?; and how „tail risk? investment allows losses to be shifted onto the taxpayer. In principle, the high franchise values associated with market power assist regulatory capital requirements to check risk-taking. But when big banks act strategically, bailout expectations can undermine these disciplining devices: and the taxpayer ends up „on the hook?- as in the recent crisis. That structural change is needed to prevent a repeat seems clear from the Vickers report, which proposes to protect the taxpayer by a „ring fence?separating commercial and investment banking.