V.V. Chari and Christopher Phelan write,
the anticipation of bailouts creates incentives for banks to herd in the sense of making similar investments. This herding behavior makes bailouts more likely and potential crises more severe. Analyses of bailouts and moral hazard problems that focus exclusively on bank size are therefore misguided in our view, and the policy conclusion that limits on bank size can effectively solve moral hazard problems is unwarranted.
Pointer from James Pethokoukis. My argument against big banks is not that they are more prone to moral hazard. It is that they are better able to exploit political power to obtain regulatory leniency ex ante and bailouts ex post.
Don’t you mean too correlated to avoid failing?
Banks have always been prone to herding behavior. It long precedes TBTF. The epidemic of bank failures during the Great Depression and the S & L Crisis was not the result of TBTF.
The collective lobbying efforts of small banks was always plenty potent. Too interconnected to fail will probably be more a cause of future bailouts than too big to fail. That and a comparison of the results of not doing bailouts in the Great Depression with doing them afterwards.
Finding a way to make it more likely that management and bondholders pay more of a price in the event of future bailouts might be a more promising way to avoid them.
Good points by Greg. There are also plenty of other specific examples of bank herding behavior, such as Latin American debt in the 1970’s and early 1980’s. More generally, bank regulation almost certainly increases herding behavior, because both quantitative and qualitative assessments of bank assets by regulators push banks toward favoring certain types of assets, such as making loans secured by hard assets and real estate.