Risk externalities and too big to fail

This paper establishes the case for a fallacy of economies of scale in large aggregate institutions and the effects of scale risks. The problem of rogue trading and excessive risk taking is taken as a case example. Assuming(conservatively) that a firm exposure and losses are limited to its capital while external losses are unbounded, we establish a condition for a firm not to be allowed to be too big to fail. In such a case, the expected external losses second derivative with respect to the firm capital at risk is positive. Examples and analytical results are obtained based on simplifying assumptions and focusing exclusively on the risk externalities that firms too big to fail can have. (C) 2010 Elsevier B.V. All rights reserved.