When bigger isn’t better: bailouts and bank behaviour, Discussion Paper No. 8602 (September), CEPR, London. i40 bailouts and bank reform at Pennsylvania State U niversity

Taking retail deposits and lending to SMEs and households were the traditional role of commercial banks: but banking in Britain has been transformed by increasing consoli-dation and by the lure of high returns available from investment banking. With ap-propriate changes to the Diamond and Dybvig model of commercial banking, we show how market concentration enables banks to collect ‘seigniorage ’ profits; and how ‘tail risk ’ investments which escape regulatory notice allow losses to be shifted onto the taxpayer. In principle, the franchise values associated with market power might assist regulatory capital requirements to check risk-taking. But when big banks act strategic-ally, bailout expectations can undermine these disciplining devices: and the taxpayer ends up ‘on the hook ’- as in the recent crisis. Structural change is needed to prevent a repeat; and we discuss how the Vickers report proposes to protect the taxpayer by a ‘ring fence ’ separating commercial and investment banking. JEL classifications: E41, E58, G21, G28. To depart on any occasion from [the principles of the banking trade], in consequence of some flattering speculation of extraordinary gain, is almost always extremely dangerous and frequently fatal to the banking company which attempts it. (Ada