Too big to fail

2 The economics of TBTF

This section describes what happened during the global financial crisis and explains the economics of the TBTF problem.

What happened during the global financial crisis?

recession

The US National Bureau of Economic Research defines it as a period when output is declining. It is over once the economy begins to grow again. An alternative definition is a period when the level of output is below its normal level, even if the economy is growing. It is not over until output has grown enough to get back to normal. The latter definition has the problem that the ‘normal’ level is subjective.

financial stability

A state in which the financial system is always able to perform its economic functions. A stable financial system: (1) can absorb financial and real economic shocks, (2) can prevent contagion and feedback effects and (3) should neither cause nor excessively amplify a downturn in overall economic activity. Market participants can constantly adapt to evolving conditions or exit the market without jeopardising the functioning of the financial system. Macroprudential policy should be formulated such that it safeguards financial system stability. Source: Bundesbank glossary.

Banks provide crucial services to the economy. They grant credit, provide savers with a place to keep their cash, and they facilitate payments (for more details on the day-to-day activities of banks, see Section 10.8 of The Economy 1.0). Interruption of these services is incredibly costly to the economy and its participants. When an individual bank fails, its customers may be unable to pay their bills, and its borrowers may have to repay their loans. That is costly for customers. But when the banking system as a whole gets into trouble, the consequences for the economy can be even more severe. Financial crises are strongly associated with recessions and unemployment.

What causes financial crises? Financial stability is at risk if small shocks to a single bank can threaten the stability of the financial system and harm the real economy by disrupting the system’s core functions, as described above. Such contagion can arise not only where banks are too large or too connected to fail, but also where many banks are exposed to the same types of risks.

This is what happened during the global financial crisis. When Lehman Brothers filed for bankruptcy, it triggered the crisis, exposing vulnerabilities in the global financial system that reached far beyond the failure of an individual bank.

mortgage (or mortgage loan)

A loan contracted by households and businesses to purchase a property without paying the total value at one time. Over a period of many years, the borrower repays the loan, plus interest. The debt is secured by the property itself, referred to as collateral. See also: collateral.

liquidity

Persons and enterprises are liquid if they are able to fulfil their payment obligations at any time. Correspondingly, assets can be categorised according to their degree of liquidity or how readily they can be converted into cash. Cash is the most liquid asset. While financial assets like shares and bonds traded in the markets have a lower degree of liquidity than cash, they are much more liquid than real estate owing to the much lengthier process of selling property. Source: Bundesbank glossary.

asset

Anything of value that is owned. See also: balance sheet.

net worth

Assets less liabilities. See also: balance sheet.

maturity transformation

The practice of borrowing money short-term and lending it long-term. For example, a bank accepts deposits, which it promises to repay at short notice or no notice, and makes long-term loans (which can be repaid over many years). Also known as: liquidity transformation.

Lehman, like other financial institutions, had suffered large losses on financial products linked to mortgages. In the fall of 2008, investors began to worry about whether Lehman could absorb the losses. Its share price fell and its short-term funding dried up. Because the market was not willing to roll over Lehman’s short-term debt, the bank faced a liquidity crisis: it did not have enough cash and liquid assets to pay its debts as they fell due. Even banks with positive net worth are vulnerable to this risk because they engage in maturity transformation. For further details, see Section 10.8 of The Economy 1.0.

For an account of the Lehman case, you can read the book The Fed and Lehman Brothers: Setting the Record Straight on a Financial Disaster, or listen to this podcast, in which the author, Laurence Ball, discusses the book’s main ideas.

For further details on the global financial crisis, see Sections 17.8, 17.9, 17.10 and 17.11 of The Economy 1.0. To learn more about the risks in the mortgage market and implications for financial stability during the global financial crisis, you can read the article ‘Systemic Risk in the Financial Sector: An Analysis of the Subprime-Mortgage Financial Crisis’ by Martin Hellwig, or the book Fault Lines: How Hidden Fractures Still Threaten the World Economy by Raghuram Rajan.

At the time, Lehman was not considered to be TBTF. It was large, but not very large: it was the fourth-largest investment bank in the US. The bank therefore went into regular bankruptcy proceedings in the jurisdictions in which it operated. On the day it failed, Lehman reported assets of $639 billion. (By way of comparison, JPMorgan Chase’s assets were over $2 trillion.) Yet the Lehman Brothers’ insolvency triggered a financial crisis. It turned out to be ‘too connected to fail’ or ‘too complex to fail’ in an orderly manner. Banks are often highly interconnected through their lending and trading activities. Moreover, if they become exposed to similar kinds of risk, such as the mortgage-linked financial products that triggered Lehman’s losses, they may also become indirectly connected and hence vulnerable to contagion.

interbank market

A market in which banks borrow to and lend from each other.

solvent

A firm or individual for which net worth is positive or zero. For example, a bank whose assets are more than its liabilities (what it owes). See also: insolvent.

Therefore, when Lehman filed for bankruptcy, market participants suspected that other banks could be in trouble as well. Banks became reluctant to lend to each other in the interbank market. The interbank market, however, is a crucial channel through which banks receive funding: many of them roll over their short-term debt every night, as Lehman did. The result was a ‘liquidity run’: even sufficiently capitalized, solvent banks were at risk of not receiving short-term funding.

fire sale

The sale of something at a very low price because of the seller’s urgent need for money.

positive feedback (process)

A process whereby some initial change sets in motion a process that magnifies the initial change.

Banks tried to generate cash by selling assets. While this was a rational choice for each bank, it was disastrous for the system. With all banks trying to offload similar assets as fast as they could, asset prices fell sharply, which generated further losses for the banks. The fire sales of assets created a positive feedback process in the financial system, and lending to the real economy declined. (Section 17.9 of The Economy 1.0 explains how feedback processes work in asset markets.)

For more details on how markets determine the value of financial assets, see Sections 11.5 and 11.6 of The Economy 1.0 (or Sections 10.8 and 10.9 of Economy, Society, and Public Policy).

insolvent

An entity is insolvent if the value of its assets is less than the value of its liabilities. See also: solvent.

capital (firms and banks)

The money that a firm has obtained from its shareholders and any profit that it has made and not paid out.

Banks did not have enough capital to absorb the large losses. Relative to total assets, the systemically important banks had capital of only about 4% of total assets in 2007. This meant that if their assets were to fall in value by only 4%, capital would be wiped out, making them insolvent.

Hence, the Lehman failure triggered large-scale losses and disruptions in the financial system, and that eroded confidence in other financial institutions, threatening their failure. And not just one country, but the global financial system was affected.

bank run

A situation in which depositors withdraw funds from a bank because they fear that it may go bankrupt and not honour its liabilities (that is, not repay the funds owed to depositors).

Governments were therefore compelled to act to prevent widespread bank failures. They did so by bailing out the banks, assuming losses that would, in the event of bankruptcy, have fallen on the banks’ shareholders and creditors such as pension funds and other financial institutions. Generally, there are several ways to support a failing bank. One way is to inject capital in exchange for an equity stake. The government may even have to inject so much capital that it ends up nationalizing the bank. Another common way is to guarantee some or all of the bank’s liabilities, such as deposits, in order to prevent a run on the bank.

Government support prevented losses from spreading further throughout the financial system, and it mitigated the harm that the credit contractions did to the real economy. But much damage had already been done, and the crisis indeed turned out to be very costly:

For details on government bailouts during the global financial crisis, see the reports by the Congressional Budget Office and the Congressional Oversight Panel for the US, and the European Commission. Researchers Laeven and Valencia and the Financial Stability Board provide information on systemically important institutions that failed or received official support.

• Costs for the real economy: The advanced market economies were at the centre of the global financial crisis. While global output declined by only 0.1% in 2009, output losses were substantially higher in the advanced economies (−3.3%). In the EU, output declined by 4.5% in 2009, which practically wiped out the growth of the three previous years. Output losses were even more staggering in smaller countries hosting large financial institutions. In Ireland, for example, GDP declined by 4.5% in 2008 and by 5% in 2009.
• Costs for the taxpayer: Data put together by Laeven and Valencia (2018) show that the direct fiscal costs of supporting the financial sector reached a third of GDP in countries such as Greece, Iceland, and Ireland, which were hit hardest by the global financial crisis. Governments also felt indirect effects: they lost tax revenue and spent more on social welfare as economies shrank. Government debt in the Euro Area increased from 66% of GDP in 2007 to 80% in 2009.
• Political and social costs: The crisis also had long-lasting social costs. Unemployment increased markedly and persistently, and inequality increased. Many repercussions of the 2009 crisis can still be felt today. In a speech given at the World Economic Forum in Davos in 2019, German chancellor Angela Merkel stated, ‘It [the crisis] caused an incredible loss of confidence—in politics, but also in the economic sphere, particularly in the financial sector. The regulations we introduced—to better control the banks—were a step forward, but if you ask people in our countries, you will find that their belief in a stable international financial sector has been damaged quite significantly. Therefore we have to do everything to avoid a repetition of the crisis.’

Moral hazard and systemic risk externalities

external effect

A positive or negative effect of a production, consumption, or other economic decision on another person or people that is not specified as a benefit or liability in a contract. It is called an external effect because the effect in question is outside the contract. Also known as: externality. See also: incomplete contract, market failure.

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 events of 2008 show how costly it can be if moral hazard leads banks to take on excessive risk and if external effects for the stability of the financial system are not internalized. (See Section 12.7 of The Economy 1.0 for an explanation of how moral hazard and external effects operate in credit markets.)

Other financial entities such as insurance companies and pension funds play very important roles in the financial system, too, and their relative importance is increasing. Indeed, non-bank financial intermediaries now own nearly half of global financial assets. But the focus of this CORE Insight is on banks, because of their prominent role in the global financial crisis and the subsequent reforms.

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https://books.core-econ.org/insights/too-big-to-fail/02-the-economics-of-tbtf.html#figure-1

Figure 1 The economics of TBTF.

Financial Stability Board (FSB) 2021

Figure 1 takes a closer look at how decisions taken by banks, governments, and market participants interact to lead to a TBTF problem (FSB 2021, p. 12):

balance sheet

A record of the assets, liabilities, and net worth of an economic actor such as a household, bank, firm, or government.

funding structure of bank

Every bank has two sources of funds: capital and debt. Debt is the money that it has borrowed from its creditors and will have to pay back. Debt includes among other things deposits from customers, debt securities issued and loans taken out by the bank. Source: ECB.

resolution

The process of closing or restructuring a bank without interrupting its critical economic functions. Bank shareholders and some or all of the bank’s creditors bear the losses, instead of taxpayers. One approach to resolution is bail-in. See also: bail-in.

implicit guarantees

Where market participants believe that the government would support a bank in case of its financial distress to avoid feedback effects with the real economy, the bank and its creditors are said to enjoy an implicit guarantee. See also: funding cost advantages.

funding cost advantages

The difference between a financial institution’s actual funding cost and its hypothetical funding costs if it were not benefiting from an implicit guarantee. Funding cost advantages are a measure of the implicit government subsidy accruing to systemically important banks and thus the expected bailout that bondholders expect to receive. See also: implicit guarantees.

market failure

When markets allocate resources in a Pareto-inefficient way. Examples of market failure are moral hazard, external effects and ‘hidden actions’ problem. See also: external effects, hidden actions (problems of) and moral hazard

• Choices of banks: Let’s start with decisions taken by banks. While all financial institutions benefit from a stable and sound financial system, they differ with regard to their systemic importance. The systemic importance of banks depends on the size of their balance sheets, the riskiness of their assets, their interconnectedness, and the funding structure of the bank. These are all choices made by the management of the bank, although they are affected by their funding costs and constrained by regulation. These choices affect the probability that a bank fails and the scale of losses in case of failure.
• Choices of governments: Faced with the impending failure of a TBTF bank, a government faces an agonizing and urgent decision: should it allow the bank to fail and enter into bankruptcy? Or should the government bail out the bank, that is, cover the losses with public money? Since the crisis, regulatory reforms have introduced a third option: resolution. In brief, it is a way of allocating losses to shareholders and creditors while ensuring that the bank’s core functions are not interrupted. But in most countries the resolution option was not available when the global financial crisis struck. As we have seen, governments thus opted to bail out the banks and their creditors. Section 3 explains resolution regimes in more detail.
• Market perceptions: Banks that are more risky than others should pay more to their creditors to compensate them for the extra risk. Yet this mechanism can be distorted if creditors expect part of the risk to be covered by the government. Prior to the crisis, market participants expected that governments would support distressed banks, not least because they had done so in the past. Banks benefited from an implicit guarantee. Hence, markets were willing to lend to TBTF banks without requiring full compensation for risk, at lower interest rates than those that other banks paid. This is called a funding cost advantage. It represents an implicit subsidy received by TBTF banks. Such a subsidy is undesirable: it is a form of market failure that results in the misallocation of resources.

When there is an implicit promise of government support if a problem arises, and investors do not require full compensation for risk, this provides incentives for managers and owners of financial institutions to take on more risk than is optimal from a social point of view. Thus, the decisions of banks, governments and investors all affect each other, as illustrated in Figure 1. At the bank level, one might also observe higher wages and executive compensation, together with higher profits, encouraging risk-taking at individual level.

systemic risk (in the financial system)

The risk that problems encountered by one or more market participants, and/or the adjustments they make in response to those problems, will impair the functioning of the financial system. Source: Bundesbank glossary.

Through these channels, moral hazard also affects the overall resilience of the financial system and the provision of finance. If banks experience a negative shock to capital, their short-run response can be to curb lending or to sell assets. A reduction in lending and a fire-sale feedback loop, as described above, can amplify the adverse effects on the financial system and the real economy. These systemic risk externalities are not internalized by individual banks.

Financial institutions that do not benefit from a TBTF subsidy will also be affected: systemically important financial institutions may increase their market shares at the expense of financial institutions that do not enjoy implicit funding subsidies. Market structures and competition will thus be distorted.

Section 12.1 in The Economy 1.0 explains what external effects are, and Section 12.7 explains why they are present in credit markets. Section 17.8 in The Economy 1.0 discusses the ideas of the economist Hyman Minsky about the financial system’s contribution to macroeconomic fluctuations.

In sum, banks that are TBTF give rise to a systemic risk externality: their probability of failure increases beyond socially optimal levels because managers and owners do not have to carry the full costs associated with their decisions. They reap potential benefits but only partially bear the risks, which leads to moral hazard. Banks’ incentive schemes may also promote such behaviour if managerial compensation is tied to risk-taking in a way that does not take external effects into account.

Exercise 1 Transformation of bank balance sheet composition

Answer the following questions using the bank balance sheet in Figure 10.16 (in Unit 10 of The Economy 1.0, reproduced below) and the additional balance sheets provided below.

Assets	2006	2013	2020
Cash reserve balances at the central bank	7,345	45,687	191,127
Wholesale reverse repo lending	174,090	186,779	248,014
Loans (for example mortgages)	313,226	430,411	342,632
Fixed assets (for example buildings, equipment)	2,492	4,216	4,032
Trading portfolio assets	177,867	133,069	127,950
Derivative financial instruments	138,353	324,335	302,446
Other assets	183,414	187,770	133,314
Total assets	996,787	1,312,267	1,349,515
Liabilities
Deposits	336,316	482,736	481,036
Wholesale repo borrowing secured with collateral	136,956	196,748	276,968
Unsecured borrowing	111,137	86,693	75,796
Trading portfolio liabilities	71,874	53,464	47,405
Derivative financial instruments	140,697	320,634	300,775
Other liabilities	172,417	108,043	100,652
Total liabilities	969,397	1,248,318	1,282,632
Net worth
Equity	27,930	63,949	66,883

Figure 2 Barclays Bank’s published balance sheets for 2006, 2013, and 2020 in £m.

Barclays Bank PLC Annual Report 2013 and 2020.

collateral

An asset that a borrower pledges to a lender as a security for a loan. If the borrower is not able to make the loan payments as promised, the lender becomes the owner of the asset.

leverage ratio (for banks or households)

The value of assets divided by the equity stake in those assets.

1. Describe how liabilities and assets have changed over time, both in terms of scale (value) and structure (type of liabilities or assets). What have been the major changes since 2006?
2. Comment on what happened to Barclays Bank’s liquidity over time (no calculations required). Is this bank less or more resilient to liquidity shocks in 2020 compared to 2006 and 2013?
3. Assume that the capital ratio equals net worth (equity) divided by total assets. How has the capital ratio changed over time? Explain whether or not it is possible to calculate the leverage ratio if you only know the capital ratio.
4. Describe (without doing any calculations) how the capital ratio of the bank would be affected by a change in the prices of financial assets.