Ronald Coase: Theory of the Firm and Too Big to Fail Banks

The danger of too big to fail (TBTF) banks is well known. The question remains concerning why do they exist and what can be done about it. External break-up and capital solutions have failed. They have been defeated by well financed lobbing efforts. Hope for a market based solution building on the work of the late Ronald Coase is beginning to take shape.

According to Coase, firms exist because they reduce transactions costs compared to other forms of activity. There is a limit regarding what firms can produce internally. Once reached, performance suffers, and the firm is pressured to refocus to improve returns. For banking that limit has been reached for the TBTF banks as reflected in their mediocre returns. These institutions are not only TBTF, but also too big to manage. Evidence is provided by the almost daily revelation of operating problems and litigation.

By all rights, they should restructure. Inhibiting this effort is the offsetting funding subsidies TBTF banks receive from the government. The increasing legal costs of TBTF may be offsetting enough of the subsidy to encourage a voluntary break-up of the TBTF banks. See my attached American Banker article on this matter.  

J