"Too big to fail" is a colloquial term in regulation and public policy that implies certain financial institutions are so large and so interconnected that their failure will be disastrous to an economy, and therefore governments have a responsibility to support them when they face difficulty. The term is also referred to when businesses deal with market complications related to moral hazard, economic specialization, and monetary theory.
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.[1] One of the problems that arises is moral hazard whereby a company that benefits from these 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.[2] The term has emerged as prominent in public discourse since the 2007–2010 global financial crisis.[3]
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.[4][5][6][7]
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.[8][9] Some critics, such as Alan Greenspan, believe that such large organisations should be deliberately broken up: “If they’re too big to fail, they’re too big”.[10]
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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.[11]
The Continental Illinois National Bank and Trust Company experienced a fall in its overall asset quality during the early 1980s. Tight money, Mexico's default and plunging oil prices followed a period when the bank had aggressively pursued commercial lending business, Latin American syndicated loan business, and loan participations in the energy sector. Complicating matters further, the bank's funding mix was heavily dependent on large CDs and foreign money markets, which meant its depositors were more risk-averse than average retail depositors in the US.
The bank held significant participation in highly-speculative oil and gas loans of Oklahoma's Penn Square Bank[12]. When Penn Square failed in July 1982, the Continental's distress became acute, culminating with press rumors of failure and an investor-and-depositor run in early May 1984. In the first week of the run, the Fed permitted the Continental Illinois discount window credits on the order of $3.6 billion. Still in significant distress, the management obtained a further $4.5 billion in credits from a syndicate of money center banks the following week. These measures failed to stop the run, and regulators were confronted with a crisis.
The seventh-largest bank in the nation by deposits would very shortly be unable to meet its obligations. Regulators faced a tough decision about how to resolve the matter. Of the three options available, only two were seriously considered. Even banks much smaller than the Continental were deemed unsuitable for resolution by liquidation, owing to the disruptions this would have inevitably caused. The normal course would be to seek a purchaser (and indeed press accounts that such a search was underway contributed to Continental depositors' fears in 1984). However, in the tight-money financial climate of the early 1980s, no purchaser was forthcoming.
Besides generic concerns of size, contagion of depositor panic and bank distress, regulators feared the significant disruption of national payment and settlement systems. Of special concern was the wide network of correspondent banks with high percentages of their capital invested in the Continental Illinois. Essentially, the bank was deemed "too big to fail," and the "provide assistance" option was reluctantly taken. The dilemma now became, how to provide assistance without significantly unbalancing the nation's banking system?
To prevent immediate failure, the Federal Reserve announced categorically that it would meet any liquidity needs the Continental might have, while the Federal Deposit Insurance Corporation (FDIC) gave depositors and general creditors a full guarantee (not subject to the $100,000 FDIC deposit-insurance limit) and provided direct assistance of $2 billion (including participations). Money center banks assembled an additional $5.3 billion unsecured facility pending a resolution and resumption of more-normal business. These measures slowed, but did not stop, the outflow of deposits.
In a United States Senate hearing afterwards, the then Comptroller of the Currency C. T. Conover defended his position by admitting the regulators will not let the largest 11 banks fail.[13] Regulatory agencies (FDIC, Office of the Comptroller of the Currency, the Federal Reserve System, etc.) feared this may cause widespread financial complications and a major bank run that may easily spread by financial contagion. The implicit guarantee of too-big-to-fail has been criticized by many since then for its preferential treatment of large banks. Simultaneously, the perception of too-big-to-fail may diminish healthy market discipline, and may have influenced the decisions behind the insolvency of Washington Mutual in 2008. For example, large depositors in banks not covered by the policy tend to have a strong incentive to monitor the bank's financial condition, and/or withdraw in case the bank's policies exposes them to high risks, since FDIC guarantees have an upper limit. However, large depositors in a "too big to fail" bank would have less incentive, since they'd expect to be bailed out in the event of failure.
The Federal Deposit Insurance Corporation Improvement Act was passed in 1991, giving the FDIC the responsibility to rescue an insolvent bank by the least costly method. The Act had the implicit goal of eliminating the widespread belief among depositors that a loss of depositors and bondholders will be prevented for large banks. However, the Act included an exception in cases of systemic risk, subject to the approval of two-thirds of the FDIC Board of Directors, the Federal Reserve Board of Governors, and the Treasury Secretary.[14]
Ron Suskind claimed in his book Confidence Men that the administration of Barack Obama considered breaking up Citibank and other large banks that had been involved in the financial crisis of 2008. Suskind claims that Obama's staff, such as Timothy Geithner, refused to do so. The administration and Geithner have denied this version of events. [15][16]
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 October 2009, Sheila Bair, the current 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.".[17] A study conducted by the Center for Economic and Policy Research found that the difference between the cost of funds for banks with more than $100 billion in assets and the cost of funds for smaller banks widened dramatically after the formalization of the "too big to fail" policy in the U.S. in the fourth quarter of 2008.[18] This shift in the large banks' cost of funds was in effect equivalent to an indirect "too big to fail" subsidy of $34.1 billion per year to the 18 U.S. banks with more than $100 billion in assets.
Mervyn King, the governor of the Bank of England, called for banks that are "too big to fail" to be cut down to size, as a solution to the problem of banks having taxpayer-funded guarantees for their speculative investment banking activities. "If some banks are thought to be too big to fail, then, in the words of a distinguished American economist, they are too big. It is not sensible to allow large banks to combine high street retail banking with risky investment banking or funding strategies, and then provide an implicit state guarantee against failure."[19] However, Alistair Darling disagreed; "Many people talk about how to deal with the big banks – banks so important to the financial system that they cannot be allowed to fail. But the solution is not as simple, as some have suggested, as restricting the size of the banks".[19] As well, Alan Greenspan said that “If they’re too big to fail, they’re too big,” suggesting U.S. regulators to consider breaking up large financial institutions considered “too big to fail.” He added, “I don’t think merely raising the fees or capital on large institutions or taxing them is enough ... they’ll absorb that, they’ll work with that, and it’s totally inefficient and they’ll still be using the savings.”[10]
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)."[20]
On November 4, 2011, the Financial Stability Board released a list of 29 banks worldwide that they considered to be "too big to fail". Of the list, 17 banks are based in Europe, 8 in the U.S., and the other four in Asia:[21]