Too big to fail

1 Introduction

Prior to the global financial crisis of 2007–2008, the world’s financial system appeared to be functioning well—on the surface at least. Globally active banks had been expanding across borders, there was ample credit supply, growth was vibrant, volatility in markets was moderate, and interest rates were low.

global financial crisis

This began in 2007 with the collapse of house prices in the US, leading to the fall in prices of assets based on subprime mortgages and to widespread uncertainty about the solvency of banks in the US and Europe, which had borrowed to purchase such assets. The ramifications were felt around the world, as global trade was cut back sharply. Goverments and central banks responded aggressively with stabilization policies.

bank

A firm that creates money in the form of bank deposits in the process of supplying credit.

investment bank

A financial institution that does not make loans or accept deposits, but instead carries out other banking activities such as helping companies and public sector institutions to issue securities, trading securities, foreign exchange, and all types of financial products; and advising companies on initial public offerings, mergers and acquisitions. Source: Bundesbank glossary.

Yet, as the first signals were appearing on the horizon that fortunes would turn, it was already too late: vulnerabilities had been building up underneath the surface, and these erupted with a force not seen in decades. Interest rates increased, market valuations plummeted, credit markets tightened, and instability in financial markets spilled over into the real economy.

In the early morning hours of 15 September 2008, Lehman Brothers, the fourth largest investment bank in the US, filed for bankruptcy after 164 years in business. The failure of Lehman triggered a global financial crisis, which created huge costs in terms of fiscal expenses, output losses, unemployment, and social tensions. A large amount of taxpayers’ money was spent to support banks that threatened to fail because they did not have enough equity to absorb their losses.

too big to fail

Said to be a characteristic of large banks, whose central importance in the economy ensures they will be saved by the government if they are in financial difficulty. The bank thus does not bear all the costs of its activities and is therefore likely to take bigger risks. See also: moral hazard.

bank bailout

The government buys an equity stake in a bank or makes some other intervention to prevent it from failing.

moral hazard

This term originated in the insurance industry to express the problem that insurers face, namely, the person with home insurance may take less care to avoid fires or other damages to his home, thereby increasing the risk above what it would be in absence of insurance. This term now refers to any situation in which one party to an interaction is deciding on an action that affects the profits or wellbeing of the other but which the affected party cannot control by means of a contract, often because the affected party does not have adequate information on the action. It is also referred to as the ‘hidden actions’ problem. See also: incomplete contract, too big to fail.

The disorderly events that followed the Lehman bankruptcy showed that if banks are too large or too connected to other parts of the financial system, or too ‘systemically important’, their failure can put the entire financial system at risk. In short, they may be too big to fail (TBTF). Faced with the prospect of the failure of such a bank, governments have, in the past, often felt obliged to step in to prevent it. Such bailouts are in fact a recurrent theme in the history of financial crises. This creates an important economic distortion, namely, moral hazard: a TBTF bank does not bear all the costs of its activities and is, therefore, likely to take too many risks.

The Lehman Brothers episode showed the dilemma that governments are facing when dealing with failing banks: both options—governments saving banks and governments letting banks fail—can carry dangers.

For details on the role that the banking system has played in historical financial crises, see Sections 17.2, 17.8 and 17.11 of The Economy 1.0.

systemically important financial institution (SIFI)

A financial institution is considered systemically important if its insolvency would have a serious impact on the functioning of the domestic financial system and have negative effects on the real economy. Systematically important banks are subject to stricter capital requirements and loss absorbency capacity than other banks. Global systemically important banks and domestic systemically important banks are further classifications of systemically important financial institutions. Source: Bundesbank glossary.

The global financial crisis revealed that the regulatory framework for banks was inadequate, and that banks were simply too fragile. Policymakers introduced a whole suite of regulatory reforms over the years that followed. These reforms included new regulations aimed specifically at systemically important banks. This was the first time that the TBTF problem had been explicitly tackled.

The new regulations are intended to make crises less likely and less costly: they reduce the probability of the failure of systemically important financial institutions and improve the way in which failing banks are dealt with, so that they do not have to be bailed out by governments.

This CORE Insight looks at what happened during the global financial crisis and how regulatory reforms since then aim to address the TBTF problem by:

• explaining factors that make a bank TBTF and lead to economy-wide implications (Section 2)
• explaining how policies can be designed to tackle the TBTF problem (Section 3)
• discussing the regulatory reforms following the global financial crisis, the institutions in charge, and the policy evaluation approach (Section 4)
• discussing how the direct effects and side effects of TBTF reforms can be assessed (Section 5).

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Too big to fail: lessons from a decade of financial sector reforms