Too big to fail

Lehman Brothers

Too big to fail‘ describes financial institutions that are so large and so interconnected that their failure is widely held to be disastrous to the economy, and which therefore must be supported by government when they face difficulty. The term was popularized by Congressman Stewart McKinney in a 1984 hearing discussing the FDIC’s intervention with a failing bank, Continental Illinois.

Proponents of this theory believe that the importance of some institutions means they should become recipients of beneficial financial and economic policies from governments or central banks. One of the problems that arises is moral hazard (where costs that could incur will not be felt by the party taking the risk), in this case companies insulated by protective policies will seek to profit by it, and take positions that are high-risk high-return, as they are able to leverage these risks based on the policy preference they receive.

Some economists such as Nobel Laureate Paul Krugman hold that economy of scale in banks and in other businesses are worth preserving, so long as they are well regulated in proportion to their economic clout, and therefore that ‘too big to fail’ status can be acceptable. The global economic system must also deal with sovereign states being too big to fail.

Critics see the policy as counterproductive and that large banks or other institutions should be left to fail if their risk management is not effective. Some critics, such as Alan Greenspan, believe that such large organizations should be deliberately broken up: ‘If they’re too big to fail, they’re too big.’ Before 1950, U.S. federal bank regulators had essentially two options for resolving an insolvent institution: closure, with liquidation of assets and payouts for insured depositors, or purchase and assumption, encouraging the acquisition of assets and assumption of liabilities by another firm.

A third option was made available by the Federal Deposit Insurance Act of 1950: providing assistance, the power to support an institution through loans or direct federal acquisition of assets, until it could recover from its distress. The statute limited the ‘assistance’ option to cases where ‘continued operation of the bank is essential to provide adequate banking service.’ Regulators shunned this third option for many years, fearing that if regionally or nationally important banks were thought to be generally immune to liquidation, markets in their shares would be distorted. Thus, the assistance option was never employed during the period 1950-1969, and very seldom thereafter. Research into historical banking trends suggests that the consumption loss associated with National Banking Era bank runs was far more costly than the consumption loss from stock market crashes.

Since the full amount of the deposits and debts of ‘too big to fail’ banks are effectively guaranteed by the government, large depositors view deposits with these banks as a safer investment than deposits with smaller banks. Therefore, large banks are able to pay lower interest rates to depositors than small banks are obliged to pay. In 2009, Sheila Bair, at that time the Chairperson of the FDIC, commented that ”Too big to fail’ has become worse. It’s become explicit when it was implicit before. It creates competitive disparities between large and small institutions, because everybody knows small institutions can fail. So it’s more expensive for them to raise capital and secure funding.’ Research has shown that banking organizations are willing to pay an added premium for mergers that will put them over the asset sizes that are commonly viewed as the thresholds for being too big to fail.

According to Senator Bernie Sanders, if taxpayers are contributing to save these companies from bankruptcy, they ‘should be rewarded for assuming the risk by sharing in the gains that result from this government bailout.’ Doing so would be at least fairer. Nonetheless, if companies had not taken risks in the first place and if the Government had let them suffer the penalties, these options would not have been explored. In this sense, Alan Greenspan affirms that, ‘Failure is an integral part, a necessary part of a market system.’ Thereby, although the financial institutions that were bailout were indeed important to the financial system, the fact that they took risk beyond what they would otherwise, should be enough for the Government to let them face the consequences of their actions. It would have been a lesson to motivate institutions to proceed differently next time.

Moreover, the decision to bailout large institutions does not seem a sustainable solution. It does not fix the causes; it addresses the consequences and the interesting point is that authorities have not realized that institutions that were at the center of the crisis, namely JP Morgan Chase, Bank of America, Wells Fargo and Citigroup, have become ‘even bigger,’ representing ‘the four largest banks in America.’ Thus, economist Willem Buiter proposes a tax to internalize the massive external costs inflicted by ‘too big to fail’ institution. ‘When size creates externalities, do what you would do with any negative externality: tax it. The other way to limit size is to tax size. This can be done through capital requirements that are progressive in the size of the business (as measured by value added, the size of the balance sheet or some other metric). Such measures for preventing the New Darwinism of the survival of the fittest and the politically best connected should be distinguished from regulatory interventions based on the narrow leverage ratio aimed at regulating risk (regardless of size, except for a de minimis lower limit).’

In 2011, the Financial Stability Board released a list of 29 banks worldwide that they considered to be ‘systemically important financial institutions’ – financial organisations whose size and role meant that any failure could cause serious systemic problems. Of the list, 17 are based in Europe, 8 in the U.S., and 4 in Asia, including: Bank of America, Barclays, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, ING Bank, JPMorgan Chase, Morgan Stanley, UBS, and Wells Fargo.

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