Too Big to Fail, Too Small to Survive: How Safer National Banks Undermine Regional Banks' Stability

Abstract

This paper extends the framework of global game modeling and identifies a novel bank-run externality. Regulations strengthening large banks can inadvertently increase the fragility of smaller institutions. By enhancing the perceived safety of large banks, regulations can trigger significant deposit outflows from smaller banks, even with minor economic shocks. This weakens their stability, heightens bankruptcy risks, and creates a feedback loop where deposit competition forces smaller banks to offer higher rates, exacerbating vulnerabilities. We examine the policy implications and propose pathways to mitigate these effects.