Too Big to Fail

The too big to fail is a concept that certain banks or financial institutions cannot be let to fail, since their failure would have too much effect on the general economy thus causing financial disability on the national and even international financial systems (A dictionary of Business and Management 2).

The reasoning behind the “too big to fail” concept is that if a bank or financial institution that does business with a lot other businesses in the economy was to fail, then the rebound effect would be too much for the economy to handle. As such, the central bank is obligated to bail such financial institutions out, not so much for the sake of the individual institution, but to shield the economy from the consequences of the closure.

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According to the (A Dictionary of Business and Management 45), the too big to fail concept contends that once the central bank bails the bank, the bank willingly takes on more risks to make business more viable. The too big to fail theory is only applicable to large financial institutions connected to other financial institutions (Wessel 5).

Investors who do business with the too big to fail institutions are a less worried lot than their counterpart who trade with ordinary financial institutions because they have a “taxpayer subsidy”, which cushions them against losses (Wessel 12).

However, not all financial institutions get the bail out as indicated in the theory. In 1995, Baring Brothers, a London based Merchant Bank was not bailed out as would have been anticipated because the Bank of England did not see any risk to the financial systems in the country that could be caused by its failure. Further, it was established that the Baring Brothers had failed due to irregular trading the bank had in Singapore’s derivates market (A Dictionary of Business Management 16).

The too big to fail concept is a reaction to the continued mergers and acquisitions in the financial sectors, which leads to a complexity of financial institutions. According to (Folkerts-Landau et al 13), consolidation is mainly motivated by cost saving measures, or revenue enhancement motives.

In the wake of globalization, such financial conglomerates are no longer content with working inside territorial boundaries (A Dictionary of Business Management 25). This means that they are more willing to explore the international markets. Consequently, this exposes them to more risks.

In a free market economy, it is only plausible that market forces would close banks that do not meet their credit obligations (Hetzel 7). However, this does not happen with too big to fail financial institutions. Traditionally, the regulation of the banking sector was the mandate of bank regulators.

With the increased diversification of the financial institutions, which includes mergers among banks, insurance companies and even funds management, banking regulators are finding themselves more as observers, rather than regulators. This is mainly because with the diversification of the financial firms, systemic regulation which was the forte of the banking regulators is overwhelmed by the mere complexity.

More to this, the management of financial conglomerates is more integrated laying little emphasis on legal entities and functional regulatory authorities of national borders. Considering this, often complex financial transactions that such conglomerates handle, the occurrence of failure in the big financial institutions leans more towards systemic failures than anything else.

There is contention among financial analysts about the effect of too-big-to-fail. While one group maintains that it is a good policy to ensure that economies do not suffer as a result of a financial conglomerate going bankrupt, others (Dowd 1; Bebchuk 1) contends that this concept encourages financial institutions to take irresponsible risk, with the full knowledge that they are assured of survival since the government cannot after all let them fail. “The Too big to fail concept resulted from a deficiency in bankruptcy arrangements for banks” (Hetzel 3).

Such sentiments are aired because unlike nonfinancial institutions which are subject to bankruptcy arrangements should they fail to meet their financial obligations; banks are exempted from bankruptcy law. In its place, banks and other financial institutions can continue with normal operations as policy makers determine whether they are viable or not.

This approach is adopted because though banks may fail to meet their short term credit obligations, they are usually viable for restructuring. More to this, it is agreeable that even when a financial institution cannot be restructured, giving it time to liquidate its assets over a length of time results in more value than immediate closure.

In the absence of bankruptcy laws for the financial institutions, the Federal Reserve and the Federal Deposit Insurance Corporation (at least in the United States) has been mandated with coming up with an “informal discount window” for financial institutions for purposes of preventing abrupt closure. As such, too big to fail is perceived as a concept that arose mainly from pressures arising from unsatisfactory arrangements for closing bankrupt banks, rather from conscious decisions by policy makers (Hetzel 6).

A recent activity in the financial market was testimony to the Too big to fail concept. In the financial crisis that hit the financial markets across the world starting 2007 to 2009, Bear Sterns and AIG were among financial institutions that received government bailout.

However, Lehman Brothers did not. This left analysts as well as laymen wondering just what banking regulators and supervisors considers when deciding whether a bank is too big to fail. Literature in to this concept (Folkerts-Landau et al 13 ; Rajan 4) indicate that large financial institutions are more likely to be categorized as too big to fail compared to average or small institutions.

More to this, the potential cost to taxpayers and the general economy is also weighted before regulators and supervisors decide whether to bailout a bank or not. Notably Lehman Brothers had $691.1 billion book value worth of assets at the time of its closure, while Bear Stearns had $395.4 billion book value of assets when it was bailed out.

Too big to fail has a fair share of benefits as well as disadvantages. The benefits include the fact that banks gain favor with uninsured creditors and other participants in the market. In addition, too big to fail institutions are able to operate on lower regulatory costs thus increasing the probability of receiving more regulatory leniency.

The fact that such institutions have access to the government’s safety net means that they can operate on a lower capital base and funds as compared to other financial institutions (Folkerts-Landau et al 11). The perception that the government would bail out such institutions in an event of a financial crisis allows more uninsured creditors the luxury of doing business with the too big to fail institutions.

The disadvantages however seem to outweigh the good since the concept reduces discipline in the financial markets by encouraging excessive risk taking by the financial institutions, creating uneven playing fields for smaller and emerging financial institutions, and costing the government and the tax payer a lot of money, should a bail-out be deemed necessary (Cloutier 4).

In the wake of a need to find a solution to the cost that the too big to fail institutions cost the government in bailouts or the entire risk they pose to the economy should they be allowed to fail, several remedies have been suggested.

First, analysts, (Rajan 6; Cloutier 4) suggests that “bank regulators need resolution authority over the too big to fail institutions, just the same way that the FDIC has resolution authority over banks.” Currently, regulators have no authority over the resolution of banking holding companies or non-banking institutions.

More transparency in the financial sectors is also recommended as one of the too big to fail remedy (Rajan 6). Currently, regulators and supervisors only have piecemeal information regarding the operations of most banking institutions. Without such information, supervisors especially have a hard time conducting onsite examination of the financial institutions and their subsidiaries.

In an ideal situation, supervisory authorities have the legal mandate to conduct examinations of data provided to them by the banks, verify the same, restrain any unsound practices by the banks and in extreme circumstances, force the banks to exit (Folkerts-Landau et al 13)

Breaking up the too big to fail institutions may be the least desirable action to the players, but such an action would be the most ideal to completely resolve the risk issues posed by such institutions to the entire economy (Cloutier 3). This however would be a systemic approach that could take years before enforcement since it would need policy formulation and willingness on the part of the financial players.

In an address to congress, (Cloutier 13) stated that “the prevailing financial system is too concentrated, and lacking the necessary regulation. The four largest banking companies in the United States today control an excess of 40 percent of the country’s deposits, an excess of 50 percent of all assets held by banks in the entire country.”

Such concentration is prone to political pressures especially where guarantees on the public sector are needed to guarantee the banks’ liabilities (Folkerts-Landau et al 13). With this statistics, it is rather obvious that the too big to fail institutions pose a major risk to the economy. Having a more diverse banking sector would not only reduce the risk, but would also promote competition and innovation, in addition to availing consumers more channels of credit and business.

Dealing with the already established too big to fail financial institutions or the too-interconnected business which are hard to regulate and manage can be through breaking them up, or forcing them to divest assets (Cloutier 4). The latter would reduce the risk that such institutions pose to the financial systems.

More so, preventing others from coming up, through regulating the extent to which a financial institution can grow is also a viable alternative (Rajan 13). With these solutions in mind, it is however proper to acknowledge the process of growth that leads to the too big to fail institutions. Unlike what most people would be tempted to believe, these institutions follow an organic growth path, mainly as a result of efficiency in management and strategic planning.

Through expansion and growth, most of them realize the profits that come with business growth. To some, diversification is a mode of risk reduction. As such, a number have invested not only in traditional-like banking systems, but have also diversified their investments into mutual funds and insurance. This makes the remedies suggested above even more hard to enact across the board.

Even if regulators and supervisory authorities were given the freehand to handle these banks, the mere amount of books, information and business is just overwhelming (Rajan 4). This is because the institutions have assets, gross-derivatives positions, liabilities, net-derivatives positions, profitability margins and transactions, all which form a reasonable metric through which the regulators can impose a limit.

Conclusion

The expansion, mergers and acquisitions that led to the creation of too bog to fail institutions is tantamount to mixing commerce and banking. This is a dangerous precedent that will continue posing systemic risks in the financial sector (Coutier 11).

In the United States, the mandate to find lasting solutions to this concept lies with the concept, which has the powers to initiate policy frameworks that would infuse regulation, assessment and the eventual disintegration of financial institutions that are too big for the general good of the economy.

Further, it is still within Congress’ mandate to come up with policies that would prevent future concentration of commercial and financial powers in institution since such are the source of the current too big to fail institutions. After all, the phrase “if it’s too big to fail, it’s probably too big to exist” might contain some wisdom that may shield the financial markets in the future.

Works Cited

A Dictionary of Business and Management. “Too Big to Fail”. Encyclopedia.com. 2006. 19 Feb. 2010, from: http://www.encyclopedia.com.

Bebchuk, Lucian. “AIG still isn’t Too Big to Fail.” The Wall Street Journal. March 2009. February 19, 2010, from:
.

Cloutier, Couns. “Too Big to Fail: The Role of the Anti-trust Law in Government-Funded Consolidation in the Banking Industry.” Testimony of Mr. C.R. Cloutier, president and CEO, MidSouth Bank, NA. March 2009. February 19, 2010,from: http://judiciary.house.gov/hearings/pdf/Cloutier090317.pdf.

Dowd, Kevin. “Too Big to Fail? Long Term Capital Management and the Federal Reserve.” CATO institute Briefing Papers. No. 51 (1996):1-12. Print

Folkerts-Landau , David. F., Lindgren, Carl-Johan and IMF. Toward a framework for financial stability. New York: International Monetary Fund, 1998.Print.

Hetzel, Robert, L. “Too Big to Fail. Origins, Consequences, and Outlook.” Economic Review. (1991): 4-13.

Rajan, Raghuram. “Too Systemic to Fail: Consequences, causes and Potential remedies.”Written Statement to the Senate Banking Committee Hearings. May 6, 2009. February 19, 2010, from:
www.banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=40ba6d40-c960-4abe-82d0-d41cbd0b028f.

Wessel, David. “Three Theories on Solving the ‘Too Big to Fail’ Problem.” The Wall Street Journal. October 29, 2009. February 19, 2010, from:
.

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