The CORE Econ website uses essential cookies to make our website work. You may disable these using your browser settings but this may affect website functionality (such as your access to logged-in resources). We would also like to use analytics cookies to help us improve the functionality of our website and improve your user experience. These analytics cookies will be set only if you accept. We do not sell or otherwise transfer personal data or usage data to any third parties or use it for any other purpose. For more detailed information about the cookies we use, see our Privacy policy.

Too big to fail

6 Conclusion

The global financial crisis had massive and long-lasting implications for the stability of the financial system, the real economy, and society. In contrast with the COVID-19 pandemic, which was a global health shock that deeply affected the real economy and threatened to affect the financial system, the global financial crisis originated in the financial sector and spilled over into the real economy. Large and systemically important banks were at the centre of the crisis. Before the crisis, regulation of systemically important banks was inadequate: it did not set proper incentives to mitigate risks, and it did not provide a way to deal with risks that had materialized.

Addressing these shortcomings of the regulatory framework has been the objective of post-crisis financial sector reforms. Financial regulations have been overhauled in order to increase the resilience of individual financial institutions, to reduce moral hazard, and to prevent the build-up of systemic risk in the financial system.

This CORE Insight has focused on TBTF policies. It has:

  • shown that the existence of banks that are too big to fail is an important and undesirable economic distortion, giving risk to moral hazard and systemic risk externalities.
  • shown that a bank can be TBTF not only because of its size, but also because it is highly connected to other parts of the financial system. If systemically important banks experience losses and cannot absorb these losses, their failure can put the functioning of the financial system at risk: critical infrastructure such as the payments system may not function, and lending may be cut.
  • discussed how higher capital requirements can increase the ability of banks considered TBTF to absorb losses, hence reducing the probability of their failure and the costs to the taxpayer in the event of their failure. Moreover, public authorities need tools to deal with failing banks without bailing them out or putting them into disorderly bankruptcy.
  • argued that the effects and side effects of TBTF reforms need to be assessed from a social, economy-wide perspective. Effective TBTF reforms may mean higher funding costs for systemically important banks, because implicit funding subsidies decline. But this can have positive effects for society as a whole, as costs of bailouts decrease and as banks reduce their risk-taking. Effective TBTF reforms may mean that systemically important banks have lower market shares. But this does not necessarily mean less funding for the real economy because other financial institutions pick up the business.

Overall, the case is not closed. Indicators of bank behaviour and systemic risk have moved in the intended direction, and public authorities now have the tools to deal with failing banks. But we cannot really know whether a bank is TBTF until it fails and we see how the authorities deal with it. Solving the TBTF problem is an ongoing project. Regulations addressing systemic risk externalities have to be implemented and enforced. Other financial intermediaries have entered the scene, and non-bank financial intermediation has gained in importance. Even if the TBTF problem has been mitigated in the banking system, it could arise in the non-bank financial sector. Addressing TBTF risks and monitoring risks to financial stability therefore remain a priority.