Too Big To Fail And Too Big To Save: Dilemmas For Banking Reform

Auburn University; Milken Institute

Chapman University; University West

December 17, 2015

Abstract:

“Too big to fail” traditionally refers to a bank that is perceived to generate unacceptable risk to the banking system and indirectly to the economy as a whole if it were to default and unable to fulfill its obligations. Such a bank generally has substantial liabilities to other banks through the payment system and other financial links, which can be sources of contagion if a bank fails. The main objectives in this paper are to identify the different dimensions of “too big to fail” and evaluate various proposed reforms for dealing with this problem. In addition, we document the various dimensions of size and complexity, which may contribute to or reduce a bank’s systemic risk. Furthermore, we provide an assessment of economic and political factors shaping the future of “too big to fail.”

Too Big To Fail And Too Big To Save: Dilemmas For Banking Reform – Introduction

‘Too big to fail’ traditionally refers to a bank that is perceived to generate unacceptable risk to the banking system and indirectly to the economy as a whole if it were to default and unable to live up to its obligations. Unlike non-financial firms banks generally have substantial liabilities to other banks through the payment system and other financial links, which can be sources of ‘contagion” if a bank fails.

In the United States, the practice of treating troubled big banks differently from troubled small ones dates back to the 1984 bailout of Continental Illinois Corporation. That taxpayer-funded rescue was based on fears that a bank collapse of Continental’s magnitude would destabilize the entire financial system (see, for example, Kaufman, 2002; Shull, 2010; and Barth, Prabha, and Swagel, 2012). Those same fears prompted far bigger bank bailouts, both in the U.S. and Europe, during the recent global financial crisis. In the wake of that experience, regulators and banking experts almost unanimously agree that regulatory reform is essential to ensuring that no bank is ever again too big to fail.

After the Great Recession “too big to fail” has become a concern for financial firms more broadly, since there is substantial interconnectedness among financial institutions involved in financial market trading activities that generate liquidity in the markets for a variety of financial instruments. The financial crisis in 2007-2009, which contributed to the Great Outside the U.S. the policy responses to banking crises have long been characterized by general bailouts of banks’ creditors (and sometimes shareholders as well) in the form of, for example, blanket guarantees, unlimited liquidity support or state nationalization as documented in Caprio, et al., (2005) and Honohan and Klingebiel (2003). One explanation is that few countries outside the U.S. have had established special legal procedures for bank insolvencies until very recently. Failing banks in most countries had to be resolved under general corporate insolvency law. Resolution under such laws is time-consuming and not suitable for failing banks with liabilities that support liquidity in the economy.

After the Continental Illinois failure the U.S. resolution procedures for banks were strengthened with the implementation of the Federal Deposit Insurance Corporation Improvement Act (FDICIA) in 1991. Under these procedures small and midsized banks in the U.S. have been allowed to fail with consequences for banks’ uninsured creditors. The bailout of large banks but not small and midsized banks during the financial crisis in 2008 and 2009 established ‘too big to fail’ and the differential treatment of such banks.

Financial reforms outside the U.S. since the 2007-2009 crisis include the implementation of special procedures for bank resolution, in particular in the EU, with the intention to address the ‘too big to fail’ problem as well. In the U.S. the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) includes procedures for resolving large banks. We argue that the credibility of these procedures are critical for the future of ‘too big to fail.’

The differential treatment of large banks has been formalized in the designation of 30 banks as globally systemically important banks (G-SIBs) and a larger number of systemically important financial institutions (SIFIs). These designations have implications for their regulation and supervision, as well as for the degree to which these financial institutions may enjoy implicit subsidies in costs of funding as we will discuss below.

We use the concept of ‘too big to fail’ to incorporate ‘too complex to fail’ as well. We discuss factors affecting complexity and the impact of these factors on systemic risk. Although complexity and size are far from perfectly correlated as we will see below, increased complexity essentially implies that a financial institution becomes ‘too big to fail’ at a smaller size.