Big Banks and Credible Threats

Game theory suggests that, in repeated games, one player may attempt to influence the outcome of the game by making threats. We see that in the case of labour-management negotiations: ‘if you don’t give us a pay raise, we will go on strike’, or ‘if you don’t accept our final offer, we will lock you out’. For these tactics to work, the threat must be credible. That is, the player receiving the threat must believe that the player making the threat will actually carry through with it. This is the theory behind an article in the Telegraph regarding the regulation of big banks in the U.S. and Britain.

After the financial collapse of 2007-2008, governments have looked at increasing the oversight and regulation of the financial sector. This is particularly true in the U.S. and Britain where government bailouts were the largest. For obvious reasons, banks have no desire to be regulated. In response to the prospect of greater regulation, big banks have threatened to move their operations to other countries. Banking is a service industry, and as such, can be operated in any country in the world. The potential for job losses and the reduction in tax revenues is supposed to make politicians reconsider their positions.

The problem for the banks is that the threat isn’t credible. Suppose that Barclay’s Bank wanted to move their operations out of the UK. The question is where would they go? Certainly not to the U.S. where politicians are also making regulations stricter. Definitely not Canada where banking regulation is much stricter than the U.K. Perhaps Iceland or Ireland will take them, given that they are both on the verge of bankruptcy from bailing out their own banks. Greece, Portugal and Spain don’t have the resources or the willingness to backstop big banks in the event of another financial crisis.

If rating agencies such as Moody’s and Fitch downgrade sovereign debt rating as a result of a big bank moving into their country, the increased debt costs may outweigh any benefit from job creation and tax revenue.

The banks’ threat is simply not credible. Governments will increase banking regulation and oversight. Shareholders will lose, taxpayers will gain. Game theory in action.