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Too big to fail

The "too big to fail" theory asserts that certain corporations, particularly financial institutions, are so large and so interconnected that their failure would be disastrous to the greater economic system, and they therefore must be supported by government when they face potential failure.[1] 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.[2] The term had previously been used occasionally in the press.[3]

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.[4] 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.[5][6][7][8]

Opponents believe that one of the problems that arises is

  • "The structure and the story of the To Big To Fail Banks" (PDF). 2009-05-11. 
  • "Carping about the TARP: Congress wrangles over how best to avoid financial Armageddon".  
  • Kaufman, George G. (1990). "Are Some Banks Too Large to Fail? Myth and Reality".  
  • 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.  
  • 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.  
  • Stern, Gary H.; Feldman, Ron J. (2004). Too Big to Fail: The Hazards of Bank Bailouts. Washington, DC: Brookings Institution Press.  
  • Moseley, Fred (January–February 2009). "Time for Permanent Nationalization".  
  • Who is Too Big to Fail?: Does Title II of the Dodd-Frank Act Enshrine Taxpayer Funded Bailouts?: Hearing before the Subcommittee on Oversight and Investigations of the Committee on Financial Services, U.S. House of Representatives, One Hundred Thirteenth Congress, First Session, May 15, 2013
  • Who Is Too Big To Fail: Are Large Financial Institutions Immune from Federal Prosecution?: Hearing before the Subcommittee on Oversight and Investigations of the Committee on Financial Services, U.S. House Of Representatives, One Hundred Thirteenth Congress, First Session, May 22, 2013
  • Federal Reserve - List of Banks with Assets Greater than $10 billion

Further reading

  1. ^ "Too Big to Fail, Too Blind to See". ssrn.com. 
  2. ^ Dash, Eric (2009-06-20). "If It's Too Big to Fail, Is It Too Big to Exist?". New York Times. Retrieved 2009-06-22. 
  3. ^  
  4. ^ "What is too big to fail? definition and meaning". Businessdictionary.com. Retrieved 2013-04-27. 
  5. ^ a b Paul Krugman "Financial Reform 101" April 1, 2010
  6. ^ a b Paul Krugman "Stop 'Stop Too Big To Fail'." April 21, 2010
  7. ^ a b Paul Krugman "Too big to fail FAIL" June 18, 2009
  8. ^ a b Paul Krugman "A bit more on too big to fail and related" June 19, 2009
  9. ^ Ennis, Huberto M.; Malek, H.S. "Federal Reserve Bank of Richmond Economic Quarterly Volume 91/2 Spring 2005" (PDF). 
  10. ^ Turner, Adair. "Too Much 'Too Big to Fail'?" Economist's View. September 2, 2010.
  11. ^ "Banks 'Too Big to Fail'? Wrong". Businessweek.com. 
  12. ^ Charles G. Leathers, J. Patrick Raines, Benton E. Gup, Joseph R. Mason, Daniel A. Schiffman, Arthur E. Wilmarth Jr., David Nickerson, Ronnie J. Phillips, Marcello Dabós, George G. Kaufman, Joe Peek, James A. Wilcox, Chris Terry, Rowan Trayler, Steven A. Seelig, Júlia Király, Éva Várhegyi, Adrian van Rixtel; et al. (2003-12-30). Benton E. Gup, ed. Too Big to Fail: Policies and Practices in Government Bailouts. Westport, Connecticut: Praeger Publishers. p. 368.  
  13. ^ a b "Greenspan Says U.S. Should Consider Breaking Up Large Banks". Bloomberg. 2009-10-12. Retrieved 2010-02-05. 
  14. ^ a b c "Top Economists and Financial Experts Say We Must Break Up the Giant Banks". The Big Picture. Ritholtz.com. Retrieved 14 March 2013. 
  15. ^ Harding, Robin; Atkins, Ralph (31 March 2014). "Problem of banks seen as 'too big to fail' still unsolved, IMF warns".  
  16. ^  
  17. ^ Moenninghoff, S.C., Ongena, S., Wieandt, A. "The Perennial Challenge to Abolish Too-Big-To-Fail in Banking: Empirical Evidence from the New International Regulation Dealing with Global Systemically Important Banks". Retrieved May 22, 2014. 
  18. ^ a b c "Bernanke-Causes of the Recent Financial and Economic Crisis". Federalreserve.gov. 2010-09-02. Retrieved 2013-05-31. 
  19. ^ FDIC Deposit Insurance Summary-Retrieved November 17, 2013
  20. ^ Krugman, Paul (May 13, 2012). "Why We Regulate". New York Times. 
  21. ^ "Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007". ssrn.com. 
  22. ^ a b c Zandi, Mark (2010). Financial Shock. FT Press.  
  23. ^ Ben Bernanke-The Crisis as a Classic Financial Panic-November 2013
  24. ^ a b Heaton, Hal B.; Riegger, Christopher. "Commercial Banking Regulation - Class discussion notes" (PDF). marriottschool.byu.edu. 
  25. ^ """The Cost of Banking Panics in an Age before "Too Big to Fail (PDF). Federal Reserve Bank of Chicago. November 2011. 
  26. ^ Bradley, Christine; Craig, Valentine V. (2007). "Privatizing Deposit Insurance: Results of the 2006 FDIC Study" (PDF). FDIC Quarterly 1 (2). pp. 23–32. 
  27. ^ "Graph: Gross Domestic Product". stlouisfed.org. 
  28. ^ "5-Bank Asset Concentration for United States". stlouisfed.org. 
  29. ^ "FRED Graph". stlouisfed.org. 
  30. ^ Wheelock, David. "Banking Industry Consolidation and Market Structure-Federal Reserve Bank of St. Louis" (PDF). Review-November/December 2011. 
  31. ^ Wiseman, Paul; Gogoi Pallavi (2009-10-19). "FDIC chief: Small banks can't compete with bailed-out giants". USA Today. Retrieved 2009-10-22. 
  32. ^ "How Much Would Banks Be Willing to Pay to Become "Too-Big-to-Fail" and to Capture Other Benefits?" (PDF). Federal Reserve Bank of Kansas City. July 2007. 
  33. ^  
  34. ^ Phillip Swagel (29 November 2013). "Reducing the Impact of Too Big to Fail". The New York Times. 
  35. ^ "Why Should Taxpayers Give Big Banks $83 Billion a Year?". Bloomberg.com. 
  36. ^ "How to Know When We’ve Ended the $83 Billion Bank Subsidy". Bloomberg.com. 
  37. ^ "The Impact of Government Interventions on CDS and Equity Markets". ssrn.com. 
  38. ^ a b The Price of Too Big to Fail By Brendan Greeley, businessweek.com, 5 July 2012
  39. ^ a b Simon Johnson and John E. Parsons (25 April 2013). "The Treasury’s Mistaken View on Too Big to Fail". The New York Times. 
  40. ^ Krozner, Randall (November 2013). "A Review of Bank Funding Cost Differentials" (PDF). 
  41. ^ Bloomberg-Mark Whitehouse-Moody's Thinks We've Solved Too Big to Fail-November 15, 2013
  42. ^ Dash, Eric (20 June 2009). "If It's Too Big to Fail, Is It Too Big to Exist?". New York Times. Retrieved 16 September 2012. 
  43. ^ Sanders, Bernie (19 September 2008). "Billions for Bailouts! Who Pays?". The Huffington Post. Retrieved 16 September 2012. 
  44. ^ McKee, Michael (15 October 2009). "Greenspan Says U.S. Should Consider Breaking Up Large Banks". Bloomberg. Retrieved 16 September 2012. 
  45. ^ Ted Kaufman (29 July 2013). "Why DOJ Deemed Bank Execs Too Big To Jail". Forbes. 
  46. ^ a b Mattingly, Phil (March 6, 2013). "Too-Big-to-Fail Banks Limit Prosecutor Options, Holder Says". Bloomberg. Retrieved 14 March 2013. 
  47. ^ Holder, Eric (March 2013). "Testimony to the Senate Committee on the Judiciary". video. United States Senate. Retrieved 13 April 2013. 
  48. ^ Boyer, Peter J. (May 6, 2012). "Why Can't Obama Bring Wall Street to Justice?". The Daily Beast. Retrieved 13 April 2013. 
  49. ^ a b Richard W. Fisher; Harvey Rosenblum (March 10, 2013). "Fisher and Rosenblum: How to Shrink the 'Too-Big-to-Fail' Banks". Wall Street Journal. Retrieved 14 March 2013. 
  50. ^ a b Dayen, David (March 21, 2013). "Banks Are Too Big to Fail Say ... Conservatives?". The American Prospect. Retrieved 23 March 2013. 
  51. ^ a b Yglesias, Matthew (March 21, 2013). "What Problem Does Breaking Up The Banks Fix?". Slate. Retrieved 23 March 2013. 
  52. ^ Breslow, Jason (March 5, 2013). """Senators Bash DOJ for "Evasive" Response on "Too Big To Jail.  
  53. ^ Senators Charles Grassley and Sherrod Brown (March 1, 2013). """Unsatisfactory Response from Justice Department on "Too Big to Jail. Retrieved March 18, 2013. 
  54. ^ Abrams, Rachel; Lattman, Peter (22 November 2013). "Ex-Credit Suisse Executive Sentenced in Mortgage Bond Case". The New York Times. 
  55. ^ Raymond, Nate (22 November 2013). "UPDATE 2-Former Credit Suisse trader Serageldin gets 30 months in jail". Reuters. 
  56. ^ The Rise of Corporate Impunity: Meet the only Wall St. executive prosecuted as a result of the financial crisis. Has justice been served?
  57. ^ a b "Does Size Matter? Simon Johnson vs. Paul Krugman on Whether to Break Up "Too Big to Fail" Banks". The Huffington Post. 12 April 2010. 
  58. ^ "Joseph E. Stiglitz on Too Big to Live - Project Syndicate". Project Syndicate. 
  59. ^ Goldman Sachs-Annual Report 2012
  60. ^ Patterson, Scott (27 February 2013). "Volcker Rule Could be Delayed -- Again". Wall Street Journal. Retrieved 1 March 2013. 
  61. ^ "A Roadmap of the Shadow Banks, plus targeting the Volcker Rule". Rortybomb. 
  62. ^ "Ezra Klein - Too big to fail in two dimensions". washingtonpost.com. 
  63. ^ Carter Dougherty (12 July 2013). "Warren Joins McCain to Push New Glass-Steagall Law for Banks". Bloomberg.com. 
  64. ^ Buiter, Willem (June 24, 2009). "Too big to fail is too big". The Financial Times. Retrieved 2009-11-22. 
  65. ^ "Policy Measures to Address Systemically Important Financial Institutions" (PDF). Financial Stability Board. 2011-11-04. Retrieved 2011-11-04. 
  66. ^ Simon Johnson (1 August 2013). "Sadly, Too Big to Fail Is Not Over". The New York Times. 
  67. ^ Lynch, S. N. (19 February 2013). "Senator Warren's rebuke of regulators goes viral". Reuters. Retrieved 10 March 2013. 
  68. ^ United Press International (UPI), “Lagarde: 'Too big to fail' banks 'dangerous'” Retrieved April 13, 2013
  69. ^ Book Details Dissension in Obama Economic Team, by MARK LANDLER, New York Times, September 15, 2011
  70. ^ Geithner denies ignoring Obama's request on banks Associated Press, via CBSnews.com, September 19, 2011 2:31 PM
  71. ^ a b Treanor, Jill (2009-06-17). "'"King calls for banks to be 'cut down to size. The Guardian (London). Retrieved 2009-06-18. 
  72. ^ Gallup, Inc. "Americans' Confidence in Banks Up for First Time in Years". gallup.com. 
  73. ^ Ben Protess (1 August 2011). "Wall Street Continues to Spend Big on Lobbying". The New York Times. 
  74. ^ "Lobbying Spending Database Finance, Insurance & Real Estate, 2013 - OpenSecrets". opensecrets.org. 
  75. ^ Belly Up, Phillip Zweig, Ballantine Books, 1986
  76. ^ 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. 
  77. ^ Greenspan, Alan (2007). The Age of Turbulence: Adventures in a New World. The Penguin Press. pp. 193–195.  
  78. ^ The Canadian Press (2013-03-26). "Canada's big 6 banks are too big to fail, regulator says - Business - CBC News". Cbc.ca. Retrieved 2013-04-27. 
  79. ^ '+nick_name+' (2013-03-24). "Bernard Hickey: Still too big to fail - Business - NZ Herald News". Nzherald.co.nz. Retrieved 2013-04-27. 
  80. ^ "British Might End Too Big To Fail Banking | FDL News Desk". News.firedoglake.com. 2013-02-04. Retrieved 2013-04-27. 
  81. ^ "Video Communications & Investment Banking, Part 1: Restructuring in response to bank breakup" (PDF). www.videocentric.co.uk. 2014-06-04. Retrieved 2014-06-23. 

Notes

Works:

General:

Banking collapse:

See also

The too-big-to-fail idea has led to legislators & governments facing the challenge of limiting the scope of these hugely important organisations, and regulating activities perceived as risky or speculative - to achieve this regulation in the UK, banks are advised to follow the UK's Independent Commission on Banking Report.[81]

[80] The British Chancellor (finance minister)

United Kingdom

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.[79]

New Zealand

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)."[78]

Canada

International

LTCM was founded in 1994 by John W. Meriwether, the former vice-chairman and head of bond trading at Salomon Brothers. Members of LTCM's board of directors included Myron S. Scholes and Robert C. Merton, who shared the 1997 Nobel Memorial Prize in Economic Sciences for a "new method to determine the value of derivatives". Initially successful with annualized returns of over 40% (after fees) in its first years, in 1998 it lost $4.6 billion in less than four months following the Russian financial crisis requiring financial intervention by the Federal Reserve, with the fund liquidating and dissolving in early 2000.[77]

Long-Term Capital Management L.P. (LTCM) was a hedge fund management firm based in Greenwich, Connecticut that utilized absolute-return trading strategies combined with high financial leverage. The firm's master hedge fund, Long-Term Capital Portfolio L.P., collapsed in the late 1990s, leading to an agreement on September 23, 1998 among 14 financial institutions for a $3.6 billion recapitalization (bailout) under the supervision of the Federal Reserve.

Long-Term Capital Management

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.[76]

Controversy

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.

Stopping the run

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?

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.

Regulatory crisis

The bank held significant participation in highly speculative oil and gas loans of Oklahoma's Penn Square Bank.[75] 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.

Payments crisis

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 participation 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.

Distress

An early example of a bank rescued because it was "too big to fail" was the Continental Illinois National Bank and Trust Company during the 1980s.

Continental Illinois case

Prior to the 2008 failure and bailout of multiple firms, there were "too big to fail" examples from the 1980s and 1990s. These included Continental Illinois and Long-Term Capital Management.

Historical examples

The banking industry spent over $100 million lobbying politicians and regulators between January 1 and June 30, 2011.[73] Lobbying in the finance, insurance and real estate industries has risen annually since 1998 and was approximately $500 million in 2012.[74]

Lobbying by banking industry

Gallup reported in June 2013 that: "Americans' confidence in U.S. banks increased to 26% in June, up from the record low of 21% the previous year. The percentage of Americans saying they have "a great deal" or "quite a lot" of confidence in U.S. banks is now at its highest point since June 2008, but remains well below its pre-recession level of 41%, measured in June 2007. Between 2007 and 2012, confidence in banks fell by half—20 percentage points." Gallup also reported that: "When Gallup first measured confidence in banks in 1979, 60% of Americans had a great deal or quite a lot of confidence in them -- second only to the church. This high level of confidence, which hasn't been matched since, was likely the result of the strong U.S. banking system established after the 1930s Great Depression and the related efforts of banks and regulators to build Americans' confidence in that system."[72]

Public opinion polls

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".[71] 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."[13]

Mervyn King, the governor of the Bank of England during 2003-2013, called for cutting "too big to fail" banks 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."[71]

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.[69][70]

Other commentators

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 had to be controlled with "comprehensive and clear regulation [and] more intensive and intrusive supervision."[68]

International organizations

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.[46] 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.[49] Other conservatives including Thomas Hoenig, Ed Prescott, Glenn Hubbard, and David Vitter also advocated breaking up the largest banks.[50][51]

One of the most vocal opponents in the United States government of the "too big to fail" status of large American financial institutions in recent years has been the newly elected U.S. Senator from Massachusetts, Elizabeth Warren. At her first U.S. Senate Banking Committee hearing on February 14, 2013, Senator Warren pressed several banking regulators to answer when they had last taken a Wall Street bank to trial and stated, "I'm really concerned that 'too big to fail' has become 'too big for trial.'" Videos of Warren's questioning, centering on "too big to fail", became popular on the internet, amassing more than 1 million views in a matter of days.[67]

Politicians

Economist Simon Johnson has advocated both increased regulation as well as breaking up the larger banks, not only to protect the financial system but to reduce the political power of the largest banks.[39][57][66]

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. Krugman wrote in January 2010 that it was more important to reduce bank risk taking (leverage) than to break them up.[5][6][7][8]

More than fifty economists, financial experts, bankers, finance industry groups, and banks themselves have called for breaking up large banks into smaller institutions.[14] (See also Divestment.)

Economists

Commentary

[65] On November 4, 2011, a policy research and development entity, called the

Monitoring

Economist Willem Buiter proposes a tax to internalize the massive 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)."[64]

Too big to fail tax

Another major banking regulation, the Glass–Steagall Act from 1933, was effectively repealed in 1999. The repeal allowed depository banks to enter into additional lines of business. Senators John McCain and Elizabeth Warren proposed bringing back Glass-Steagall during 2013.[63]

The Dodd-Frank Act includes a form of the Volcker Rule, a proposal to ban proprietary trading by commercial banks. Proprietary trading refers to using customer deposits to speculate in risky assets for the benefit of the bank rather than customers. The Dodd-Frank Act as enacted into law includes several loopholes to the ban, allowing proprietary trading in certain circumstances. However, the regulations required to enforce these elements of the law were not implemented during 2013 and were under attack by bank lobbying efforts.[60][61][62]

Banks are required to maintain a ratio of high-quality, easily sold assets, in the event of financial difficulty either at the bank or in the financial system. These are capital requirements. Further, since the 2008 crisis, regulators have worked with banks to reduce leverage ratios. For example, the leverage ratio for investment bank Goldman Sachs has declined from a peak of 25.2 during 2007 to 11.4 in 2012, indicating a much-reduced risk profile.[59]

The United States passed the Dodd-Frank Act in July 2010 to help strengthen regulation of the financial system in the wake of the subprime mortgage crisis that began in 2007. Dodd-Frank requires banks to reduce their risk taking, by requiring greater financial cushions (i.e., lower leverage ratios or higher capital ratios), among other steps.

The leverage ratio, measured as debt divided by equity, for investment bank Goldman Sachs from 2003-2012. The lower the ratio, the greater the ability of the firm to withstand losses.

Reduce risk-taking through regulation

For example, economist Joseph Stiglitz wrote in 2009 that: "In the United States, the United Kingdom, and elsewhere, large banks have been responsible for the bulk of the [bailout] cost to taxpayers. America has let 106 smaller banks go bankrupt this year alone. It’s the mega-banks that present the mega-costs...banks that are too big to fail are too big to exist. If they continue to exist, they must exist in what is sometimes called a “utility” model, meaning that they are heavily regulated." He also wrote about several causes of the crisis related to the size, incentives, and interconnection of the mega-banks.[58]

More than fifty economists, financial experts, bankers, finance industry groups, and banks themselves have called for breaking up large banks into smaller institutions.[14] This is advocated both to limit risk to the financial system posed by the largest banks as well as to limit their political influence.[57]

Break-up the largest banks

The solutions to the "too big to fail" issue are controversial. Some options include breaking up the banks, reducing risk taking through regulation, bank taxes that increase for larger institutions, and increased monitoring.

Solutions

Kareem Serageldin pleaded guilty on November 22, 2013 for his role in inflating the value of mortgage bonds as the housing market collapsed, and was sentenced to two and a half years in prison.[54][55] As of April 30, 2014, Serageldin remains the “only Wall Street executive prosecuted as a result of the financial crisis” that triggered the Great Recession.[56]

In a January 29, 2013 letter to Holder, Senators Sherrod Brown (D-OH) and Charles Grassley (R-IA) had criticized this Justice Department policy citing "important questions about the Justice Department’s prosecutorial philosophy."[52] 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."[53]

Four days later, Federal Reserve Bank of Dallas President Richard W. Fisher and Vice-President Harvey Rosenblum 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 8 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," advocating the withholding from mega-banks access to both Federal Deposit Insurance and Federal Reserve discount window, 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.[49] Other conservatives including Thomas Hoenig, Ed Prescott, Glenn Hubbard, and David Vitter also advocated breaking up the largest banks,[50] but liberal commentator Matthew Yglesias questioned their motives and the existence of a true bipartisan consensus.[51]

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."[46][47] 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.[48]

The political power of large banks and risks of economic impact from major prosecutions has led to use of the term "too big to jail" regarding the leaders of large financial institutions.[45]

Inability to prosecute

In this sense, Alan Greenspan affirms that, "Failure is an integral part, a necessary part of a market system."[44] Thereby, although the financial institutions that were bailed out 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.

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."[42] 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."[43]

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

Moral hazard

During November 2013, the Moody's credit rating agency reported that it would no longer assume the eight largest U.S. banks would receive government support in the event they faced bankruptcy. However, the GAO reported that politicians and regulators would still face significant pressure to bail out large banks and their creditors in the event of a financial crisis.[41]

Economist Randall S. Kroszner summarized several approaches to evaluating the funding cost differential between large and small banks. The paper discusses methodology and does not specifically answer the question of whether larger institutions have an advantage.[40]

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.”[39]

Another study by Frederic Schweikhard and Zoe Tsesmelidakis,[37] estimated 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.[38] For America's biggest banks the estimated savings was $53 billion for Wells Fargo, and $4 billion for AIG. The study 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.[38]

The editors of Bloomberg View estimated there was an $83 billion annual subsidy to the 10 largest United States banks, reflecting a funding advantage of 0.8 percentage points due to implicit government support, meaning the profits of such banks are largely a taxpayer-backed illusion.[34][35][36]

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.[33] 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.

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.[32]

"'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."[31]

In October 2009, Sheila Bair, at that time the Chairperson of the FDIC, commented:

Since the full amount of the deposits and debts of "too big to fail" banks are effectively guaranteed by the government, large depositors and investors view investments with these banks as a safer investment than deposits with smaller banks. Therefore, large banks are able to pay lower interest rates to depositors and investors than small banks are obliged to pay.

Implicit guarantee subsidy

The number of U.S. commercial and savings bank institutions reached a peak of 14,495 in 1984; this 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.[30]

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.[29]

[22] This concentration continued despite the

The largest U.S. banks continue to grow larger while the concentration of bank assets increases. The largest six U.S. banks had assets of $9,576 billion as of year-end 2012, per their 2012 annual reports (SEC Form 10K). For scale, this was 59% of the U.S. GDP for 2012 of $16,245 billion.[27] 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.[28]

Bank size, complexity, and interconnectedness with other banks may inhibit the ability of the government to resolve (wind-down) the bank without significant disruption to the financial system or economy, as occurred with the Lehman Brothers bankruptcy in September 2008. This risk of "too big to fail" entities increases the likelihood of a government bailout using taxpayer dollars.[22]

Percentage of banking assets held by largest five U.S. banks from 1997-2011.
Assets of largest U.S. banks per FY2012 Annual Reports

Bank size and concentration

Analysis

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.[26]

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.[24] 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.[25]

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.[24]

Resolution authority

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 crisis of 2008. One of the results of the Panic of 1907 was the creation of the Federal Reserve in 1913.[23]

Investment banks, along with other innovations in banking and finance referred to as the Troubled Asset Relief Program in 2008.[21][22]

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 also are "market makers" in that they serve as intermediaries between two investors that wish to take opposite sides of a financial transaction. The Glass-Steagall Act separated investment and depository banking until its repeal in 1999. Prior to 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 and the shadow banking system

Prior to 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 deposits at the same time. Since banks lend most of the deposits and only retain a fraction in the proverbial vault, a bank run can render the 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 ($250,000 in 2013).[19] 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.[20]

Depository banks

Background on banking regulation

  1. 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."
  2. 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."
  3. 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."[18]

Bernanke cited several risks with too-big-to-fail institutions:[18]

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 crisis has a single lesson, it is that the too-big-to-fail problem must be solved."[18]

Definition

Contents

  • Definition 1
  • Background on banking regulation 2
    • Depository banks 2.1
    • Investment banks and the shadow banking system 2.2
    • Resolution authority 2.3
  • Analysis 3
    • Bank size and concentration 3.1
    • Implicit guarantee subsidy 3.2
    • Moral hazard 3.3
    • Inability to prosecute 3.4
  • Solutions 4
    • Break-up the largest banks 4.1
    • Reduce risk-taking through regulation 4.2
    • Too big to fail tax 4.3
    • Monitoring 4.4
  • Commentary 5
    • Economists 5.1
    • Politicians 5.2
    • International organizations 5.3
    • Other commentators 5.4
  • Public opinion polls 6
  • Lobbying by banking industry 7
  • Historical examples 8
    • Continental Illinois case 8.1
      • Distress 8.1.1
      • Payments crisis 8.1.2
      • Regulatory crisis 8.1.3
      • Stopping the run 8.1.4
      • Controversy 8.1.5
    • Long-Term Capital Management 8.2
  • International 9
    • Canada 9.1
    • New Zealand 9.2
    • United Kingdom 9.3
  • See also 10
  • Notes 11
  • Further reading 12

In 2014, the International Monetary Fund and others said the problem still had not been dealt with.[15][16] 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.[17]

[14] large banks into smaller institutions.breaking up More than fifty prominent economists, financial experts, bankers, finance industry groups, and banks themselves have called for [13]

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