The Too-Big-to-Fail problem is worsening, and the macroeconomic effects could be quite unpleasant. While it's no secret that the top-tier banks have had a competitive edge over the rest of the banking sector, new research shows that the U.S. government's efforts to prevent a systemic breakdown have driven an even more pronounced wedge than previously thought between the top 18 banks and everybody else. As a result, a continuing, perhaps more debilitating credit crunch for small businesses seems likely, which would slow what is already expected to be a sluggish recovery in U.S. economic growth.

Dean Baker, co-director of the Center for Economic and Policy Research, says the rescue of the financial system has entrenched a TBTF policy in the U.S. His research indicates that a "big-bank subsidy" has emerged, with TBTF banks enjoying a significant break in borrowing costs compared with smaller institutions. From the first quarter of 2000 through fourth-quarter 2007 the spread between average costs of funds for smaller banks and those with more than $100 billion in assets came to 0.29 percentage points. From fourth-quarter 2008 through the first half of this year that gap widened to 0.78 percentage points.

The increase "implies a government subsidy of $34.1 billion a year to the 18 banking holding companies with assets of more than $100 billion in the first quarter of 2009," according to a paper by Baker and CEPR research intern Travis McArthur.

Baker believes such a subsidy could "shift at least some money away from small business to speculative investments, and that would certainly be a drag on growth." He thinks the subsidy could persist indefinitely if the structure of the banking system remains unchanged.

Without strong regulatory control of TBTF institutions, many economists believe, smaller banks will be squeezed even more, depriving entrepreneurial companies of the money needed to transform a jobless uptick in GDP into a sustained rebound.

Jack Tatom, director of research at the Networks Financial Institute at Indiana State University, thinks that TBTF "is embedded for now - as long as governments can print money they can figure out a way to bail out everybody." The "unfair competition" he expects to arise will "wipe out large numbers of community banks and the businesses they support," he predicts.

And without a transparent, global regulatory approach, risky behavior by these interlinked giants will increase, and a more dangerous bubble could burst. Future crises could cascade to the point where world governments lose control of the situation, some economists say.

The prospects of a two-tiered banking sector, and systemically risky behavior, could be mitigated if TBTF institutions "are regulated more heavily and regulators are given greater resolution authority to unwind if necessary," says Marvin Goodfriend, professor of economics at Carnegie Mellon. Protecting taxpayers is essential, too. After all, enhanced resolution authority would not prevent taxpayers from ending up with the bill. "Somehow the taxpayer needs to be protected at the back end," according to Goodfriend. But politicians have no appetite for seriously dealing with the problem, he says.

Under current proposals, the Fed would be the ultimate regulator of TBTF. There are thoughts of imposing higher capital requirements on such institutions. The House Financial Services Committee released a draft bill in late October that would create a TBTF resolution process paid for by loot from the sale of assets of an institution in receivership, plus a fund fed by fees on banks with assets of $10 billion or more.

The legislation makes some progress on the resolution front, according to Douglas Elliott, a fellow in economic studies at the Brookings Institution. He believes that the TBTF model is a failure: "The economies of scale stop well short of that level." Yet putting an artificial limit on the size of financial institutions could be harmful. "I don't think we'd be better off by chopping Citi into 15 pieces." Instead, he suggests higher capitalization and liquidity requirements, and limits on "what they can do around the edges" to make it more expensive to cross the TBTF line and level the playing field by offsetting the subsidies the largest institutions now enjoy.

Tatom believes the trend toward handing the tab to the taxpayer continues unabated. Even worse, the list of the TBTF is likely to expand, not contract, in the wake of the fear and panic experienced last Autumn. "Many non-financial firms have extensive financial exposure," notes Tatom. The failure of a giant retailer could have cascading effects on the credit markets, consumers, and suppliers, for example. And it would be hard to draw the line between sectoral and systemic risks in the heat of a financial crisis.

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