Too big to fail

This article is about a theory in economics. For the 2009 Andrew Ross Sorkin book, see Too Big to Fail (book). For the film based on the book, see Too Big to Fail (film).

The "too big to fail" theory asserts that certain financial institutions are so large and so interconnected that their failure would be disastrous to the economy, and they therefore must be supported by government when they face difficulty. 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.

Proponents of this theory believe that some institutions are so important that they should become recipients of beneficial financial and economic policies from governments or central banks. Some economists such as Paul Krugman hold that economies 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.

Opponents believe that one of the problems that arises is moral hazard whereby a company that benefits from these protective policies will seek to profit by it, deliberately taking positions (see Asset allocation) that are high-risk high-return, as they are able to leverage these risks based on the policy preference they receive. The term has emerged as prominent in public discourse since the 2007–2010 global financial crisis. 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 organisations should be deliberately broken up: “If they’re too big to fail, they’re too big”. More than fifty prominent economists, financial experts, bankers, finance industry groups, and banks themselves have called for breaking up large banks into smaller institutions.

On March 6, 2013, United States Attorney General Eric Holder told the Senate Judiciary Committee that the Justice Department faces difficulty charging large banks with crimes because of the risk to the economy. Four days later, Federal Reserve Bank of Dallas President Richard W. Fisher wrote in advance of a speech to the Conservative Political Action Conference that large banks should be broken up into smaller banks, and both Federal Deposit Insurance and Federal Reserve discount window access should end for large banks. Other conservatives including Thomas Hoenig, Ed Prescott, Glenn Hubbard, and David Vitter also advocated breaking up the largest banks.

On April 10, 2013, International Monetary Fund Managing Director Christine Lagarde told the Economic Club of New York "too big to fail" banks had become "more dangerous than ever" and needed to be controlled with "comprehensive and clear regulation [and] more intensive and intrusive supervision."

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. 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.

Continental Illinois case

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 (1982) 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 certificates of deposit and foreign money markets, which meant its depositors were more risk-averse than average retail depositors in the US.

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.

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?

Stopping the run

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.

Controversy

A man at Occupy Wall Street protesting institutions deemed too big to fail.

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. Regulatory agencies (FDIC, Office of the Comptroller of the Currency, the Federal Reserve System, etc.) feared that such failures could cause widespread financial complications and a major bank run that might easily spread by financial contagion. The implicit guarantee of too-big-to-fail has been criticized by many, including the president of the Federal Reserve Bank of Dallas Richard Fisher, 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.

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. He said that Obama's staff, such as Timothy Geithner, refused to do so. The administration and Geithner have denied this version of events.

Implicit guarantee subsidy

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, at that time the Chairperson of the FDIC, commented:

"'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.

Estimated value

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. This shift in the large banks' cost of funds was in effect equivalent to an indirect "too big to fail" subsidy of $34 billion per year to the 18 U.S. banks with more than $100 billion in assets.

Another study by Frederic Schweikhard and Zoe Tsesmelidakis, employing Merton Model of pricing corporate debt, estimates the amount saved by America's biggest banks from having a perceived safety net of a government bailout was $120 billion from 2007 to 2010. For America's biggest banks the saving broke down to $53 billion for Citigroup, $32 billion for Bank of America, $10 billion for JPMorgan, $8 billion for Wells Fargo, and $4 billion for AIG. The model employs the Merton Model of pricing corporate debt, and compares the difference in confidence between stockholders and debt holders of the large banks. It noted that passage of the Dodd-Frank Act — which promised an end to bailouts — did nothing to raise the price of credit (i.e., lower the implicit subsidy) for the "too-big-too-fail" institutions.

One 2013 study (Acharya, Anginer, and Warburton) measured the funding cost advantage provided by implicit government support to large financial institutions. Credit spreads were lower by approximately 28 basis points (0.28%) on average over the 1990-2010 period, with a peak of more than 120 basis points in 2009. In 2010, the implicit subsidy was worth nearly $100 billion to the largest banks. The authors concluded: “Passage of Dodd-Frank did not eliminate expectations of government support.”

"Too big to fail is too big"

More than fifty economists, financial experts, bankers, finance industry groups, and banks themselves have called for breaking up large banks into smaller institutions. (See also Divestment.)

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."

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". 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."

Some critics have argued that "The way things are now banks reap profits if their trades pan out, but taxpayers can be stuck picking up the tab if their big bets sink the company." Additionally, as discussed by 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."

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.

Too big to fail tax

Moreover, the decision to bailout large institutions does not seem a sustainable solution. It does not fix the causes; it addresses the consequences. 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 what Rep. Bernie Sanders, called "the four largest banks in America." Thereby, the question that the Government should think about is: If one of these banks tends to fail, will we have the capacity to save it? The problem will certainly reach a point where it will be impossible for authorities to handle. Hence, a more sustainable method should be explored as well, such as letting the banks fail, with free market correction as the recovery.

Thus, 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)."

Financial Stability Board list

Main article: Systemically important financial institution

On November 4, 2011, a policy research and development entity, called 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:

Bank of America Bank of China Bank of New York Mellon Banque Populaire CdE Barclays BNP Paribas Citigroup Commerzbank Credit Suisse Deutsche Bank

Goldman Sachs Group Crédit Agricole HSBC ING Bank JPMorgan Chase Lloyds Banking Group Mitsubishi UFJ FG Mizuho FG Morgan Stanley

Nordea Royal Bank of Scotland Santander Société Générale State Street Sumitomo Mitsui FG UBS Unicredit Group Wells Fargo

2013 Attorney General Holder and Dallas Fed President Fisher comments

On March 6, 2013, United States Attorney General Eric Holder testified to the Senate Judiciary Committee that the size of large financial institutions has made it difficult for the Justice Department to bring criminal charges when they are suspected of crimes, because such charges can threaten the existence of a bank and therefore their interconnectedness may endanger the national or global economy. "Some of these institutions have become too large,” Holder told the Committee, “It has an inhibiting impact on our ability to bring resolutions that I think would be more appropriate," contradicting earlier written testimony from a deputy assistant attorney general who defended the Justice Department’s "vigorous enforcement against wrongdoing." Holder has financial ties to at least one law firm benefiting from de facto immunity to prosecution, and prosecution rates against crimes by large financial institutions are at 20-year lows.

Four days later, Federal Reserve Bank of Dallas President Richard W. Fisher co-authored a Wall Street Journal op-ed about the failure of the Dodd–Frank Wall Street Reform and Consumer Protection Act to provide for adequate regulation of large financial institutions. In advance of his March 8th speech to the Conservative Political Action Conference, Fisher proposed requiring breaking up large banks into smaller banks so that they are "too small to save," ending both Federal Deposit Insurance and Federal Reserve discount window access by larger banks, and requiring disclosure of this lack of federal insurance and financial solvency support to their customers. This was the first time such a proposal had been made by a high ranking U.S. banking official or a prominent conservative. Other conservatives including Thomas Hoenig, Ed Prescott, Glenn Hubbard, and David Vitter also advocated breaking up the largest banks, but liberal commentator Matthew Yglesias questioned their motives and the existence of a true bipartisan consensus.

In a January 29, 2013 letter to Holder, Senators Sherrod Brown and Charles Grassley had criticized this Justice Department policy citing "important questions about the Justice Department’s prosecutorial philosophy." After receipt of a DoJ response letter, Brown and Grassley issued a statement saying, "The Justice Department’s response is aggressively evasive. It does not answer our questions. We want to know how and why the Justice Department has determined that certain financial institutions are ‘too big to jail’ and that prosecuting those institutions would damage the financial system."

In Canada

Main article: Big Five (banks)

In March 2013, the Office of the Superintendent of Financial Institutions announced that Canada's six largest banks, the Bank of Montreal, the Bank of Nova Scotia, the Canadian Imperial Bank of Commerce, National Bank of Canada, Royal Bank of Canada and Toronto-Dominion Bank, are too big to fail. Those six banks accounted for 90% of banking assests in Canada at that time. As well it noted that "the differences among the largest banks are smaller if only domestic assets are considered, and relative importance declines rapidly after the top five banks and after the sixth bank (National)."

In New Zealand

Despite the government's assurances, opposition parties and some media commentators in New Zealand say that the largest banks are too big to fail and have an implicit government guarantee.

In United Kingdom

The British Chancellor (finance minister) George Osborne has threatened to break up banks which are too big to fail.

See also

• Brown–Kaufman amendment
• Greenspan Put
• Volcker Rule
• Corporate welfare

Banking collapse:

• 2008-2009 bank failures in the United States
• List of acquired or bankrupt United States banks in the late 2000s financial crisis
• List of largest U.S. bank failures

General:

• Lender of last resort
• Corporatocracy

Works:

• Too Big to Fail (book)
• Too Big to Fail (film)

Further reading

• "The structure and the story of the To Big To Fail Banks". 2009-05-11. 
• "Carping about the TARP: Congress wrangles over how best to avoid financial Armageddon". The Economist. 2008-09-23. 
• Kaufman, George G. (1990). "Are Some Banks Too Large to Fail? Myth and Reality". Contemporary Economic Policy 8 (4): 1–14. doi:10.1111/j.1465-7287.1990.tb00298.x. 
• Mishkin, Frederic S. (2006). "How Big a Problem is Too Big to Fail? A Review of Gary Stern and Ron Feldman's Too Big to Fail: The Hazards of Bank Bailouts". Journal of Economic Literature 44 (4): 988–1004. doi:10.1257/002205106779436233. 
• O'Hara, Maureen; Shaw, Wayne (1990). "Deposit Insurance and Wealth Effects: The Value of Being 'Too Big to Fail'". Journal of Finance (American Finance Association) 45 (5): 1587–1600. doi:10.2307/2328751. JSTOR 2328751. 
• Stern, Gary H.; Feldman, Ron J. (2004). Too Big to Fail: The Hazards of Bank Bailouts. Washington, DC: Brookings Institution Press. ISBN 0-8157-8152-0. 
• Moseley, Fred (January/February 2009). "Time for Permanent Nationalization". Dollars & Sense. Retrieved 2009-02-25.