This a number of jobs eliminated. Therefore, if

This essay will describe the basics of the “Too
Big to Fail” (TBTF) phenomenon in the financial sector. The focus is to
understand the problems faced by the banking industry, what government safety
net means and the central role that TBTF financial institutions played in the
financial crisis in 2008 as well as the resolution of TBTF.

Introduction

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Firms are more often than not faced with
adversaries and this sometimes lead to their failure. The failure of some firms
does not result in extreme externalities while others do. A business is
considered TBTF when it has become so large that government’s assistance will be
required to prevent its failure. Reason being that its failure will have a
disastrous ripple effect on the economy as a whole. Intuitively, if a large
company fails, companies that rely on it for portions of their income might
also be brought down, and a number of jobs eliminated. Therefore, if the cost
of a bailout is less than the cost of the failure to the economy, a government
may decide on bailout as the most cost-effective solution.

After the 2007 financial crisis, an important
lesson learnt is that some banks are too big and interwoven with the economy
that it will be costly to allow them to fail. Due to the fear of systemic
collapse, governments were pushed to bailing out financial institutions around
the world. The failure of these large interconnected banks may threaten the stability
of the financial system.

Problem
of the Banking Industry

The traditional role of a bank is to serve as
a financial intermediary. That is,
aggregate deposits from various sources and conversion of the funds into
loans. The state of a bank’s balance sheet has an important effect on lending.
A contraction in their capital means they have fewer resources to lend which
leads to a lending decrease in lending, hence decline in economic activities. A
severe deterioration of a bank’s balance sheet will likely cause it to fail. This
is because many depositors for the fear of the bank’s likely insolvency as a
result of deterioration of its balance sheet will resort to withdrawing from
their deposit accounts concurrently (this situation is referred to as bank
run). Due to asymmetric information, this fear of failure can spread
contagiously among other banks leading to a bank panic. The failure of large
number of banks within a short period of time creates a tremendous loss of
information production in financial markets and an extensive loss of financial
intermediation by the banking sector which as a result, leads to an epic
economic problem. The outcome of the bank panic is an increase in adverse
selection and moral hazard problems in the financial market, that lead to a sharper
decline in lending to facilitate productive investments thus resulting in even
worse contractions in economic activities.

Government
Safety Net

Small investors and depositors are unable to
judge the soundness of financial institutions. The only way to ensure the
integrity of banks is through the enforcement of law hence depositors rely on
government to react to impropriety and mismanagement of funds by banks. The
government safety net which protects depositors however has its associated
problems. The protected depositors tend to have no incentive to monitor the
activities of the bank, with this knowledge banks tend to take more risk than
they would usually do. That is to say, in protecting depositors, the government
creates moral hazards.  Also, since some
banks are deemed to be TBTF, the management of such banks know that if they
begin to fail the government will bail them out. This bailout awareness makes
TBTF policy limit the extent of the market discipline that depositors can
impose on banks and compounds the moral hazard problem.

Resolution
of a Failing Bank

The Federal Deposit Insurance Corporation
(FDIC) had three methods for dealing with a failing bank: it can liquidate the
bank and pay off the depositors, it can arrange for a sale of all or part of a
bank and provide funds to help with the purchase i.e. when a willing merger
partner takes over all of the failed bank’s deposits with no depositors
suffering any loss, or it can bail out the bank and keep it open with direct infusion
of funds if the failing bank was acknowledged as an essential industry to its
community. These options were first agreed upon and used in practice when dealing
with the failure of the Continental Illinois Bank in May 1984.

Of the three methods stated above, the FDIC
preferred the merger/acquisition of a failing bank. A large percentage of
commercial banks failures were resolved this way.

(URL: http://www.fdic.gov/bank/historical/history/235_258.pdf).

What
Does TBTF Mean

The problems created by the deterioration of
balance sheets, asymmetric information and moral hazard as described earlier in
the essay, are the mains reason for the slower functioning of the banking
system and even failure. Some banks fail without any notice, others before
failing, due to the large size and their vital role in the financial system, become
a concern for policy makers. In the context of this essay, the word ‘large’ does
not necessarily refer to the size of an institution, but mainly to the
important role played in the financial system and the overall economic
performance. The collapse of an important banking establishment is considered
to be a serious risk to other financial institutions and even the financial
system itself. These deteriorating banks are described using the ‘Too Big to
Fail’ term ‘a policy under which the federal government does not allow large
financial firms to fail for fear of damaging the financial system’. (Burton and
Brown, c2006, 365).

The
Financial Crisis

The first sign that the economy was in
trouble occurred in 2006. That was when housing prices started to fall. Prior
to mid-2006, there was a major housing boom in the U.S. The steady rising of house
prices coupled with the belief that these prices will continue to rise seemed
to envelop most of the individuals in and around the housing and housing financing
sectors. In the 80s, US mortgages were untapped assets. In the attempt to
expand the bond market, traders at Salomon Brothers and Drexel Burnham Lambert
having realized this, decided to look into its expansion and discovered that
steady stream of payments from US mortgages could be restructured into bonds
and sold to investors. As a result of securitization, in the late 90s and early
2000s, there was an outburst in the issuance mortgage backed securities (MBSs).
Mortgages bought by investment banks were repackaged and sold to investors.
With time, the sellable MBSs reduced which caused banks to resort to the sale
of collateralized debt obligations (CDOs) which is basically a repackage of
riskier or unsellable tranches of MBSs hence majority of the mortgages were
sub-prime. Many of the CDOs and MBSs were rated AAA (top quality) which in
reality they were not.

Since investors were not interested in the AAA
rated assets because it was expensive and with low interest rate, banks decided
to keep them on their balance sheet. This is mainly because they were
considered safe as US treasury bonds at that time which required little capital
to borrow against and essentially provided with free return. The interest rate
in the money markets were lower than the interest rates of these assets, as a
result  banks were making easy spread by
borrowing short-term in the money market to buy long-term AAA tranches of CDOs
and MBSs. Some of the top investment banks such as Morgan Stanley, Lehman
Brothers, Merrill Lynch and Bear Stearns were almost entirely funded by the
short-term borrowing.

Billions of mortgages were given to
individuals with poor credit ratings on adjustable rates. As house prices
stopped rising and started to fall, subprime mortgage default rose very fast. Investors
suddenly begun to lose confidence in the top AAA tranches and in the banks
which held large amounts of them or had exposure to such assets and the rating
downgrades of these assets reinforced the process.

The start of the crisis was when the 5th
largest investment bank in the US, Bear Stearns began experiencing difficulties
in refinancing its short-term borrowings, as its creditors’ worry about its
solvency deepened. It announced large losses in 2 of its hedge funds with
exposure to subprime assets. Bear Stearns financial difficulties became severe
as it was experiencing a run by its creditors and lost a lot more money
following its losses on the mortgage hedge funds which led it to essentially run
out of money. The Federal Reserve concluded that Bear Stearns was too large and
too interconnected to be allowed to enter into bankruptcy, so the Federal
Reserve engineered the absorption of Bear Stearns into JPMorgan Chase by
providing guarantee of $30 billion to the latter firm against losses that might
be experienced on the toxic assets of the former.

After the failure of Bear, Lehman Brothers was
the next bank to be under intense pressure and needed capital desperately, all its
efforts to raise capital from other banks were fruitless. Due to the public cry
out after the bailout of Bear, the government refused to provide any kind of
support to Lehman Brothers. However, the US Treasury organized a meeting among
the CEOs of the large banks in order to save Lehman Brothers. The banks that
were interested in a deal with Lehman Brothers were Barclays and Bank of
America. However, the UK government and regulators blocked the Barclays deal to
buy Lehman Brothers on the grounds that it would make the UK bank less stable so
the only option left was Bank of America.

During this period, all the banks were
suffering at this point but the worst affected after Lehman was the 3rd biggest
bank, Merrill Lynch. After Merrill Lynch succeeded in getting Bank of America
to acquire it, Lehman brothers was out of options with the US government still
refusing to either bail them out or provide any kind of funding for a deal.

The collapse of Lehman Brothers was followed
by the downgrading of AIG’s credit rating. AIG was however not an investment
bank but had a group called AIG Financial Products which had been issuing
derivatives called Credit Default Swaps (CDSs). The US government and Federal
Reserve thought AIG had too much counterparty exposure and was too intertwined
in the global financing system hence was ‘too big to fail’. Also for the fact
that they allowed in less than 2 days the Lehman Brothers to fail, they decided
to buy equity stakes in AIG for an amount large enough to effectively bailing
them out.

A lot of financial firms including Morgan
Stanley, Goldman Sachs, Citigroup, Wachovia, and Wells Fargo were faced with
the possibility of bankruptcy.

In search for a way to stabilize the financial
markets, the US government and Federal Reserve devised a plan to buy troubled
assets from the banks so as to reduce market uncertainties. This plan was
called the Troubled Asset Relief Program (TARP) which was slightly adjusted
later to allow the TARP program to buy equity stakes in the banks as well as
buying the assets.

In sum, TBTF became a reality for the U.S.
financial system in 2008, as manifested by the Federal Reserve’s assistance to
JPMorgan Chase in March to help it absorb Bear Stearns, the widespread
realization of the traumatic effects that Lehman’s bankruptcy had on the
financial markets in mid-September; the Federal Reserve’s decision to support
AIG within a day after the Lehman bankruptcy and the Treasury’s decision in
mid-October to spend the first TARP funds on the largest financial institutions
in the U.S.

Policies
for Dealing with TBTF Financial Institutions.

The severity of the financial crisis of 2008
and the central role played by TBTF financial institutions, has put a spotlight
on the risks posed by these firms. Policy makers and governments are of the
view that the issue of dealing with firms perceived to be too big, complex and
interconnected to fail should be top priority of regulatory reform.

The Dodd-Frank Act (DFA) was passed in US in
response to the financial crisis. The elimination of the Federal Reserve’s
discretion to provide emergency financial support through a program open only
to a single financial institution, and generally raising the bar for broader
based emergency interventions under section 13.3 of the Federal Reserve Act was
a means of putting an end to TBTF problems.

However, the DFA noted that merely restricting
the Fed’s intervention is insufficient since it does not reduce the cost to
public from the failure of a large and complex firm.  There is therefore the need to deal with the
underlying externalities and problems that give rise to TBTF in order for the
non-intervention strategy to be both fully credible and consistent with the
public interest.

To solve the TBTF problems, there is the need
to put in different measures and policies that help tackle firms’ specific
issues as well as address the structure of the financial system. These include
measures that aim towards reducing the incentives for excessive risk-taking and
to lower the probability of large financial firms failing or come close to
failure. Also, measures that will lessen the disruption to the financial system
and hence the cost their failure imposes on the broader economy. Coupled with
measures that penalize characteristics associated with the negative
externalities from failure, these changes work against the incentive to be too
big to fail.

Per the Dodd-Frank Act, the Federal Reserve is
to act as the prudential regulator for TBTF institutions that are not otherwise
covered by a robust prudential regulatory system. In addition, the Financial
Stability Oversight Council (FSOC) is in the process of identifying those
non-bank financial firms that are systemically important, and these firms will
be subjected to tougher prudential standards and supervisory oversight by the
Federal Reserve. Prudential regulation is the effort of the regulators to keep
financial institutions solvent by ensuring that these institutions hold
sufficient capital and have adequate risk controls in place. A prudential regulatory
system is necessary since it is the failure or fears of failure and the
consequent short-term creditor runs of TBTF financial institutions that is the
central problem. These institutions are likely to be large finance companies (GE
Capital), large hedge funds, large insurance holding companies (such as AIG),
and large securities clearing organizations.

As is in the case for bank regulation, minimum
capital requirements that are commensurate with the risks of the TBTF
institution must be at the core of the prudential regulation of TBTF
institutions.  The capital requirement of
internationally active bank holding companies in Basel III, consistent with the
Dodd-Frank Act, will ensure that the shareholders of firms will bear all the
firm’s losses across a much wider range of scenarios than before. This is
expected to strengthen market discipline. The capital requirement has been
raised to the extent that some of the specific activities that generate
significant externalities are now subject to higher capital charges which would
cause banks to change their business activities in ways that reduce both the
likelihood and social cost of their failure. The capital requirements have been
adjusted upward based on size, complexity, interconnectedness, global exposure
and substitutability in the new Basel. That is to say, if a bank is deemed too
big to fail thus a global systemic financial institution, then it will have to
hold a greater amount of capital relative to its risk-weighted assets compared
to a less systemic institution.

On the liquidity front, adequate liquidity
requirements are very important since the TBTF financial institutions do not
have access to the Federal Reserve as the lender of last resort. The largest,
most systemically important bank holding companies will be required to hold
liquidity buffer (liquidity coverage ratio). 
This is important in preventing the situation of banks selling illiquid
assets during times of stress. Also, the LCR will help ensure that in case the of
temporary loss of access to money market or business difficulties, the bank
will have sufficient liquid asset and buy some time to solve its underlying
problems.

Restrictions on activities that can be carried
out by these institutions also help reduce the risk of failure. This is evident
in the Volcker Rule which seeks to reduce trading risk and the likelihood of
failure by limiting proprietary trading activities.  

In addition, to prevent the largest and
complex firms from becoming larger and more complex, the Dodd-Frank Act adds
“the risk to stability of the U.S. banking or financial system” as an
additional factor to be considered in evaluating a proposed merger or
acquisition under the Bank Merger Act and the Bank Holding Company Act. However,
there is no hard and fast rule to be applied in this regard. This coupled with
the supervisory body understanding better the interconnections and pathways
through which the distress or failure of one firm impairs the larger system and
causes harm to society will help reduce the adverse systemic consequences from
failure.

The Lehman bankruptcy demonstrated that
bankruptcy is not a good resolution process for insolvent TBTF financial
institutions. Per Dodd-Frank, the Federal Deposit Insurance Corporation (FDIC),
which is the receiver for insolvent banks, is to be the receiver for TBTF
financial institutions, using the phrase “orderly liquidation authority” (OLA).
The resolution of an insolvent TBTF institution would be substantially more
complicated than the resolution of the typical small insolvent banks that the
FDIC periodically deal with mainly because TBTF institutions are likely to have
a complicated corporate structure, multiple subsidiaries that may have multiple
financing sources extensive foreign operations which will require coordination
with the relevant prudential regulations abroad.

The question that is baffling is whether the
provisions in Dodd-Frank is sufficient enough for financial institutions to be
no longer TBTF. However, to the extent that they have not experienced yet
another crisis is good news but bad news to the extent that we do not know how
well it works?

Is
TBTF a Useful Policy??

The main motivations behind TBTF policy can be
summed in the fact that the failure of the
bank can lead to systemic risk, which is a threat to financial system. The
failure of large institutions can directly cause failures of other industries
hence a collapse of the economy. The failure may cause a financial contagion leading
to a financial crisis. The main reason government is willing to protect them is
cost resulting from the failure of these large banks.

Critics have
argued that breaking up firms deemed TBTF either through enforcing a legislation requiring that
retail banking and capital markets activities should be separated or the imposition
of restrictions on firms size would be a better approach. Since the business
models of banks could be simplified and hence make room for regular assessments
and close monitoring for inaccuracies as well as give way to stricter
supervisory policies and help in detecting fraud at an earlier stage. While
this could be proven to be necessary, the approach of changing the incentives
facing large and complex firms, forcing them to become more resilient, and
making the financial system more robust to their failure is also worth
exploring. Since a new and much
reduced size threshold could sacrifice socially useful economies of scale and
scope benefits without actually solving the problem of system risk
externalities that are unrelated to balance sheet size.

It is also argued that, TBTF policies increase
the moral hazard problems for financial institutions. This is essential because
depositors lack the incentive to monitor the activities of the banks since they
know they are protected. Also, banks knowing that they would be bailed out in
case of failure turn to take more risks. That is to say TBTF policy results in
banking institutions taking on greater risks which make bank failures more
likely.

The degeneration and corruption in the
financial system is believed to be caused by the problem of TBTF. Since TBTF
enhances the ability of the financial system to misappropriate the resources from
the productive parts of the economy.

Conclusion

The problem of TBTF financial institutions is
real, this was evident in the financial crisis of 2008. A lot of lessons has
been learnt from the financial crisis based on the fact that the Dodd-Frank Act
has been enacted. Too big to fail is an unacceptable regime. The good news is
there are many efforts and progress in addressing this problem particularly in
reducing the likelihood that a large complex firm will reach the point of
distress at which society faces serious costs. The bad news however is that
some of these efforts are just in their nascent stages. If the U.S. never
experiences another financial crisis that is comparable to the 2008 crisis,
then one could say the lessons learnt and provisions made in Dodd-Frank Act
were sufficient and can be sustained on a permanent basis.

 

 

References

 

Mishkin, F (2006), “How Big a problem is Too
Big to Fail? A review of Gary Stern and Ron

Wallison, Peter J., “Too Big to Ignore: The
Future of Bailout and Dodd-Frank after the 2012 Election”, Financial Services
Outlook (Washington, D.C., American Enterprise Institution), October 2012.

Kaufman, George G. and Steven Seelig,
“Post-Resolution Treatment of Depositors at Failed Banks: Implications for the
Severity of Banking Crises, Systemic Risk, and Too Big to Fail,” Economic
Perspectives (Federal Reserve Bank of Chicago), Second Quarter 2002, pp. 27-41.

URL:

Moosa, I.A. (2010) The Myth of too Big to
Fail, New York: Palgrave Macmillan.

Stern, G.H. and Feldman, R.J (c2009) Too big
to fail: the hazards of bank bailouts, Washington, D.C.: Brookings Institution
Press.

Wall, L.D. and D.R. Peterson, 1990, The Effect
of Continental Illinois’ Failure on the Financial Performance of Other Banks,
Journal of Monetary Economics, vol. 26(1), pp., 77-99.

Rochet, J.C., 2004, Bank runs and financial
crisis: a discussion, in: S. Bhattacharya and A.W. Boot (eds), Credit,
intermediation, and the macro economy: models and perspectives, Oxford
University Press. pp. 324-336.