This study shows that investment decisions drive tail risks (i.e., systemic risk and stand-alone tail risk) of TBTF (Too-Big-to-Fail) banks, while financing decisions determine tail risks of non-TBTF banks. After the Dodd-Frank Act, undercapitalized non-TBTF banks continue to gamble for resurrection, and their stand-alone tail risk become more sensitive to funding availability and net-stable-funding-ratio than TBTF banks. We show that implementing a slimmed-down version of TBTF regulations on non-TBTF banks cannot efficiently contain the stand-alone risk of non-TBTF banks and cannot eliminate TBTF privilege. Moreover, non-TBTF banks together generate larger pressure of contagion on the real economy, and they herd more when making financing decisions after the Act. Our findings highlight the need for enhanced regulations on the liability-side of non-TBTF banks.

We study non-performing loan (NPL) transactions in China using proprietary data from a leading market participant. We find these transactions – driven by tighter financial regulation – are consistent with banks concealing non-performing assets from regulators as (i) transaction prices do not compensate for credit risks; (ii) banks fund the NPL transactions and remain responsible for debt collection; and (iii) 70% of NPL packages are re-sold at inflated prices to bank clients. These results imply NPL transactions do not truly resolve NPLs. Recognizing the hidden NPLs implies the total NPLs in China is two to four times the reported amount.

We argue that the existing literature, which justifies banking regulation by either market failures or regulation capture, cannot explain why banking is one of the most regulated industries and why banking regulation is a relatively recent institution in market economies. We present a new theory of banking regulation based on government failure. We first explain that banking as a market institution is intrinsically stable and effective, since its unique financial structure, i.e. most funds come from deposits, makes it very difficult for a bank to be refinanced when its investment projects are unsuccessful, thereby hardening their budget constraint and disciplining the bank’s investment decisions. However, the advent of modern governments, who have both the resources and incentive to bail out failing banks, destroys the stabilizing mechanism of banking. We call this government failure. Banking regulation is an institutional resolution to the government failure by restricting banks’ investment decisions before they fail. We provide historical as well as contemporary evidence to support the theory and explore predictions of the theory that are not derived in the existing theories.

Soft budget constraint refers to the situation where an economic entity expects to obtain economic assistance when in financial difficulties. During the past decade, a sizable literature has accumulated explaining the causes and consequences of the soft budget constraint. Many of the theories have traced soft budget constraint on enterprises to that on banks. However, why do banks often face soft budget constraint? How to mitigate the resulting problems? In this paper, we first show that owing to their special financial structure, banks as market institutions intrinsically face hard budget constraint and nevertheless remain stable and effective. Since banks’ finance mostly comes from deposits, it is very difficult for banks to be refinanced when their investment projects are unsuccessful due to the sequential service arrangement for bank deposits. This limitation hardens the budget constraint on banks and disciplines bankers’ investment decisions. However, the advent of instantaneous-social-welfareminded modern governments, which have both the resources and the incentives to bail out failing banks, gives rise to the soft budget constraint of banks. This causes bankers’ moral hazard problems. As an institutional solution to the resulting banking instabilities, banking regulation emerged in order to restrict banks’ investment decisions. We provide historical evidence on the genesis and symptoms of, and institutional solution to the soft budget constraint of banks over the past six hundred years to support our theory. We also conduct contemporary econometric analysis to show how the lack of government commitment to a hard budget constraint gives rise to a strict banking regulation. We further explore the predictions of our theory in the paper.