Too big to fail
The idea that in banking regulation the largest and most powerful banks are, "too big to (let) fail". Which ultimately mean those banks would have less incentive to practice thrift and sound business practices, since they'd expect to be bailed out in the event of failure.
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.[1]
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 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.
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 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 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 unsecured facility pending a resolution and resumption of more-normal business. These measures slowed, but did not stop, the outflow of deposits.
Resolution
The final deal saw FDIC buy $4.5 billion of nonperforming assets, which Continental would manage for them. The bank wrote off $1 billion of this amount, and FDIC infused a like sum via the bank's holding company. FDIC required the dismissal of top management, and acquired a controlling interest.[2]
Controversy
In a 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 to fail. Regulatory agencies (FDIC, OCC, 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. On the other hand, the perception of too-big-to-fail may diminish healthy market discipline. 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 passed in 1991 and it gave the FDIC the responsibility to rescue an insolvent bank at 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.
Notes
- ^ http://marriottschool.byu.edu/emp/HBH/mba624/Commercial%20Banking%20Regulation.pdf Heaton, Hal B., Riegger, Christopher. "Commercial Banking Regulation", Class discussion notes.
- ^ http://www.fdic.gov/bank/historical/history/vol1.html Federal Deposit Insurance Corporation, Division of Research and Statistics. "History of the Eighties — Lessons for the Future", 1997