Too Big to Fail policy

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The Too Big to Fail policy is the idea that in economic regulation the largest and most interconnected businesses are "too big to [let] fail." This means that it might encourage recklessness since the government would pick up the pieces in the event it was about to go out of business.[1] The phrase has also been more broadly applied to refer to a government's policy to bail out any corporation. It raises the issue of moral hazard in business operations.

The term is back to central stage since the start of the financial meltdown. The most important US company referred to as too big to fail is American International Group (AIG).

Some critics see the policy as wrong and counterproductive. They think big banks should be left to fail if their risk management was not effective.[2][3]

Contents

[edit] Regulatory basis

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.[4]

[edit] Continental Illinois case

[edit] Distress

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.

[edit] Payments crisis

The bank held significant participation in highly-speculative oil and gas loans of Oklahoma's Penn Square Bank. 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.

[edit] Regulatory 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?

[edit] Stopping the run

To prevent immediate failure, the Federal Reserve announced categorically that it would meet any liquidity needs the Continental might have, while 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.

[edit] Controversy

In a the 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[5]. Regulatory agencies (FDIC, Office of the Comptroller of the Currency, the Fed, 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[citation needed]. Simultaneously, the perception of too-big-to-fail may diminish healthy market discipline, and may have influenced the decisions behind insolvency of the 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.[6]

[edit] Alternatives

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."[7]

However, Alastair 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 the banks".[7]

[edit] See also

[edit] Notes

  1. ^ Federal Reserve Bank of Richmond Economic Quarterly Volume 91/2 Spring 2005 by Ennis, Huberto M.; Malek, H.S
  2. ^ Alton E. Drew, The Business Week, http://www.businessweek.com/bwdaily/dnflash/content/feb2009/db20090218_166676.htm retrieved on March 20, 2009
  3. ^ Benton E. Gup, ed (2003-12-30) (in English) (html). Too Big to Fail: Policies and Practices in Government Bailouts. Westport, Connecticut: Praeger Publishers. pp. 368. doi:10.1336/1567206212. ISBN 1-567-20621-2. OCLC 52288783. http://www.greenwood.com/books/bookdetail.asp?sku=Q621. Retrieved on 2008-02-20. "The doctrine of laissez-faire seemingly has been revitalized as Republican and Democratic administrations alike now profess their firm commitment to policies of deregulation and freemarkets in the new global economy. -- Usually associated with large bank failures, the phrase too big to fail, which is a particular form of government bailout, actually applies to a wide range of industries, as this volume makes clear. Examples range from Chrysler to Lockheed Aircraft and from New York City to Penn Central Railroad. Generally speaking, when a corporation, an organization, or an industry sector is considered by the government to be too important to the overall health of the economy, it will not be allowed to fail. Government bailouts are not new, nor are they limited to the United States. This book presents the views of academics, practitioners, and regulators from around the world (e.g., Australia, Hungary, Japan, Europe, and Latin America) on the implications and consequences of government bailouts." 
  4. ^ http://marriottschool.byu.edu/emp/HBH/mba624/Commercial%20Banking%20Regulation.pdf Heaton, Hal B., Riegger, Christopher. "Commercial Banking Regulation", Class discussion notes.
  5. ^ Conover, Charles (1984), "Testimony", Inquiry Into the Continental Illinois Corp. and Continental National Bank: Hearing Before the Subcommittee on Financial Institutions Supervision, Regulation, and Insurance of the Committee on Banking, Finance, and Urban Affairs, U.S. House of Representatives, 98th Congress, 2nd Session, 18-19 September and 4 October, pp. 98-111 
  6. ^ Bradley, Christine; Craig, Valentine V. (2007), "Privatizing Deposit Insurance: Results of the 2006 FDIC Study", FDIC Quarterly 1 (2): 23-32, http://www.fdic.gov/bank/analytical/quarterly/2007_vol1_2/privatizing_deposit_insurance.pdf 
  7. ^ a b Treanor, Jill (2009-06-17). "King calls for banks to be 'cut down to size'". The Guardian. http://www.guardian.co.uk/business/2009/jun/17/king-in-bank-reform-call. Retrieved on 2009-06-18. 

[edit] Further reading

[edit] External links

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