"Too big to fail" (TBTF) is a theory in banking and finance that asserts that certain corporations, particularly financial institutions, are so large and so interconnected with an economy that their failure would be disastrous to the greater economic system, and therefore should be supported by government when they face potential failure. The colloquial term "too big to fail" was popularized by U.S. congressman Stewart McKinney in a 1984 Congressional hearing, discussing the Federal Deposit Insurance Corporation's intervention with Continental Illinois. The term had previously been used occasionally in the press, and similar thinking had motivated earlier bank bailouts.
The term emerged as prominent in public discourse following the 2008 financial crisis.Turner, Adair. "Too Much 'Too Big to Fail'?" Economist's View. September 2, 2010. Critics see the policy as counterproductive and argue that large banks or other institutions should be left to fail if their risk management is ineffective. Some critics, such as economist Alan Greenspan, believe that such large organizations should be deliberately broken up: "If they're too big to fail, they're too big." Some economists, such as Paul Krugman, hold that financial crises arise principally from banks being under-regulated rather than their size, using the widespread collapse of small banks in the Great Depression to illustrate this argument.Paul Krugman "Financial Reform 101" April 1, 2010Paul Krugman "Stop 'Stop Too Big To Fail'." New York Times, April 21, 2010Paul Krugman "Too big to fail FAIL", New York Times, June 18, 2009Paul Krugman "A bit more on too big to fail and related", New York Times, June 19, 2009
In 2014, the International Monetary Fund and others said the problem still had not been dealt with. While the individual components of the new regulation for systemically important banks (additional capital requirements, enhanced supervision and resolution regimes) likely reduced the prevalence of TBTF, the fact that there is a definite list of systemically important banks considered TBTF has a partly offsetting impact.
Definition Federal Reserve Chair Ben Bernanke also defined the term in 2010: "A too-big-to-fail firm is one whose size, complexity, interconnectedness, and critical functions are such that, should the firm go unexpectedly into liquidation, the rest of the financial system and the economy would face severe adverse consequences." He continued that: "Governments provide support to too-big-to-fail firms in a crisis not out of favoritism or particular concern for the management, owners, or creditors of the firm, but because they recognize that the consequences for the broader economy of allowing a disorderly failure greatly outweigh the costs of avoiding the failure in some way. Common means of avoiding failure include facilitating a merger, providing credit, or injecting government capital, all of which protect at least some creditors who otherwise would have suffered losses. ... If the has a single lesson, it is that the too-big-to-fail problem must be solved."
Bernanke cited several risks with too-big-to-fail institutions: These firms generate severe moral hazard: "If creditors believe that an institution will not be allowed to fail, they will not demand as much compensation for risks as they otherwise would, thus weakening market discipline; nor will they invest as many resources in monitoring the firm's risk-taking. As a result, too-big-to-fail firms will tend to take more risk than desirable, in the expectation that they will receive assistance if their bets go bad." It creates an uneven playing field between big and small firms. "This unfair competition, together with the incentive to grow that too-big-to-fail provides, increases risk and artificially raises the market share of too-big-to-fail firms, to the detriment of economic efficiency as well as financial stability." The firms themselves become major risks to overall financial stability, particularly in the absence of adequate resolution tools. Bernanke wrote: "The failure of Lehman Brothers and the near-failure of several other large, complex firms significantly worsened the crisis and the recession by disrupting financial markets, impeding credit flows, inducing sharp declines in asset prices, and hurting confidence. The failures of smaller, less interconnected firms, though certainly of significant concern, have not had substantial effects on the stability of the financial system as a whole."
Background on banking regulation
Depository banks Before the Great Depression, U.S. consumer bank deposits were not guaranteed by the government, increasing the risk of a bank run, in which a large number of depositors withdraw their funds simultaneously. Since banks lend out most of their deposits and only keep a fraction on hand, a bank run can render a bank insolvent. During the Depression, hundreds of banks became insolvent, and depositors lost their money. As a result, the U.S. enacted the 1933 Banking Act, sometimes called the Glass–Steagall Act, which created the Federal Deposit Insurance Corporation (FDIC) to insure deposits up to a limit of $2,500, with successive increases to the current $250,000.FDIC Deposit Insurance Summary Retrieved November 17, 2013 In exchange for the deposit insurance provided by the federal government, depository banks are highly regulated and expected to invest excess customer deposits in lower-risk assets. After the Great Depression, it became a problem for financial companies that they are too big to fail, because there is a close connection between financial institutions involved in financial market transactions. It brings liquidity to the markets of various financial instruments. The crisis in 2008 began when the liquidity and value of financial instruments held and issued by banks and other financial institutions declined sharply.
Investment banks and the shadow banking system In contrast to depository banks, investment banks generally obtain funds from sophisticated investors and often make complex, risky investments with the funds, speculating either for their own account or on behalf of their investors. They are also "market makers" in that they serve as intermediaries between two investors who wish to take opposite sides of a financial transaction. The Glass–Steagall Act separated investment and depository banking until its repeal in 1999. Before 2008, the government did not explicitly guarantee the investor funds, so investment banks were not subject to the same regulations as depository banks and were allowed to take considerably more risk.
Investment banks, along with other innovations in banking and finance collectively referred to as the shadow banking system, had grown to rival the depository system by 2007. They were subject to the equivalent of a bank run in 2007 and 2008, in which investors (rather than depositors) withdrew funding from the shadow system. This run became known as the subprime mortgage crisis. During 2008, the five largest U.S. investment banks either failed (Lehman Brothers), were bought out by other banks at fire-sale prices (Bear Stearns and Merrill Lynch), or were at risk of failure and obtained depository banking charters to obtain additional Federal Reserve support (Goldman Sachs and Morgan Stanley). In addition, the government provided bailout funds via the Troubled Asset Relief Program in 2008.
Fed Chair Ben Bernanke described in November 2013 how the Panic of 1907 was essentially a run on the non-depository financial system, with many parallels to the 2008 crisis. One of the results of the Panic of 1907 was the creation of the Federal Reserve in 1913.Ben Bernanke-The Crisis as a Classic Financial Panic-November 2013
Resolution authority Before 1950, U.S. federal bank regulators had essentially two options for resolving an insolvent institution: 1) closure, with liquidation of assets and payouts for insured depositors; or 2) 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 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.
The Federal Deposit Insurance Corporation Improvement Act was passed in 1991, giving the FDIC the responsibility for rescuing an insolvent bank by the least costly means. The Act had the implicit goal of eliminating the widespread belief among depositors that large banks would be protected from losses among depositors and bondholders. 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.
Analysis
Bank size and concentration
Bank size, complexity, and interconnectedness with other banks may inhibit the government's ability to resolve (wind down) the bank without significant disruption to the financial system or the economy, as occurred with the Lehman Brothers bankruptcy in September 2008. The risk of "too big to fail" entities increases the likelihood of a government bailout funded by taxpayer dollars.
The largest U.S. banks continue to grow larger while the concentration of bank assets increases. The six largest U.S. banks had assets of $9,576 billion as of year-end 2012, according to their 2012 annual reports (SEC Form 10-K). The top 5 U.S. banks had approximately 30% of the U.S. banking assets in 1998; this rose to 45% by 2008 and to 48% by 2010, before falling to 47% in 2011.
This concentration continued despite the subprime mortgage crisis and its aftermath. During March 2008, JPMorgan Chase acquired the investment bank, Bear Stearns. Bank of America acquired investment bank Merrill Lynch in September 2008. Wells Fargo acquired Wachovia in January 2009. Investment banks Goldman Sachs and Morgan Stanley obtained depository bank holding company charters, which gave them access to additional Federal Reserve credit lines.
Bank deposits for all U.S. banks ranged between approximately 60–70% of GDP from 1960 to 2006, then jumped during the crisis to a peak of nearly 84% in 2009 before falling to 77% by 2011.
The number of U.S. commercial and savings banks peaked at 14,495 in 1984; it fell to 6,532 by the end of 2010. The ten largest U.S. banks held nearly 50% of U.S. deposits as of 2011.
Implicit guarantee subsidy Since the full amounts of deposits and debts of "too big to fail" banks are effectively guaranteed by the government, large depositors and investors view investments in these banks as safer than deposits at smaller banks. Therefore, large banks can pay lower interest rates to depositors and investors than small banks are obliged to pay.
In October 2009, Sheila Bair, at that time the Chairperson of the FDIC, commented: