Tuesday, December 8, 2009

Pricing immortality

By way of the excellent economics clearing house that is The Economist's Free Exchange comes an interesting piece of research.

One of the big talking points of the financial crisis has been the idea that institutions can be too big to be allowed to fail - and hence, must be rescued whenever they encounter difficulty. This has some very straightforward consequences. If I know that I will never be bankrupted, I can borrow more cheaply, as there is less risk that I will default compared to a normal institution. In turn, I will have higher profits and in the long run take an even larger market share. This is often called the moral hazard problem, although the term is more commonly used in relation to whole-of-market regulation.

So, given that being too big to fail is an attractive status to have, it must be worth something. That's where the American economists Elijah Brewer and Julapa Jagtiani have stepped in. Their paper examines mergers from 1991-2004, and calculates the extra price paid in order to create companies that were newly too big to fail. On average, getting over the threshold costs around $1.75bn a time. In exchange for corporate immortality, that's quite a cheap insurance policy.

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