The concept of Too Big to Fail (TBTF) is used to describe financial institutions that are very large and are interconnected with other institutions and contribute a big part of the economy such that, when they fail, they have serious effects on the local economy. TBTF are normally an economic disaster and the government must support them when they face difficulties to avert the problem.
The main cause of the TBTF problem results from the interconnectedness that exists between large financial institutions and other business firms. Large banks generate big undesirable financial externalities that destabilize the stability of other firms. Most large banks provide credit facilities to households and businesses and disruptions would definitely affect the operations of this business.
The impact or loss experienced is dependent on the interconnectedness that exists between the financial institution and other business that exist in the network supported by the failing financial institutions. The great negative externalities create a problem for the policymakers/ government since the danger of these failing institutions can cause a wider problem to other businesses. The government has no option but to step in and save the financial institution in question.
Most government are likely to support the TBTF institutions as compared to other less complex organizations and hence most of these TBTF have a tendency to exercise less control in their operations and are less disciplined since they have the prospects of being rescued by the policy makers. The American government passed the FDIC act in 1991 proposes that the government should use the least costly method to rescue an insolvent bank (Dudley 6).
The impact of the TBTF problem was experienced in the late 2007 when most nations helped struggling financial sectors recover from losses. During this period, banks were offered liquidity support, capital injections and others were nationalized.
The concept of TBTF came into practice in 1984 when FDIC took over the continental Illinois national bank and trust company which was one of the largest banks in the US. FDIC compensated creditors while the shareholders lost their money. This was seen as the government action to bailout the financial institution where the creditors were bailed out but not the equity holders (Meltzer 1).
Causes of TBtF Issue
One of the main causes of the TBTF problem is the excessive growth of financial institutions both locally and internationally. As banks continue to grow, they become increasingly complex and bigger attaining a big market share both locally and internationally. This increased growth has results to complexities in administration and this finally results to failure.
Another cause of TBTF problem is the excessive credit growth which contributes significantly to the banking crises around the world. Various researchers have also indicated that weak economic growth, high inflation rates and the real interest rates are important in predicting economic crises in the banking sector and hence, it is necessary to check them as they are likely to cause crises.
Another imperative cause of banking failure is poor management practices. Properly managed banks have a tendency to survive harsh economic conditions due to proper planning and use of advanced risk management practices. The probability of a bank survival in the USA is determined by the ratios such as capital: assets ratio, the non-performing ratio, and loan: assets ratio and certificate: deposit ratio.
For banks in Europe, the main determinants of a bank in crises are loan-loss provisions, capital: assets, non performing loan: assests and the bank earnings. All these ratios are likely indicators of a looming TBTF problem. Good management practices and proper risk mitigation strategies have a great impact on the ability to save a bank from failure.
The other cause of the too big to fail problem is the existing policy and financial institutions regulations. Different countries have varying laws that control the operations of banks. These rules and regulation affect and regulate the different banks. The government failure to regulate large banks is also a cause of TBTF problem.
Problems of the “TBtF” issue
There are many problems that are direct results from the TBFT. The failure of the big bank is likely to have far reaching effects to both the business and the households. Small businesses depend upon banks for credit facilities and when these banks fail, they lack of money to perform their operations. The same case applies to individuals who rely on banks for loans and other financial support (Dudley 6).
Another great impact of the TBTF is the use of taxpayers’ money to bail out these banks. Most of the large banks have a wide scale of operations and the money required to bail them out is quite substantial as compared to the taxpayer’s money generated by a given country. The use of taxpayers’ money will have financial implications on the country’s financial and economic progress.
Another great issue arises from the need to control the operation of large banks. Some of the TBTF have branches in the major areas of the world and financial problems affecting other areas such as inflation and regional financial instabilities may affect the bank. In this case, the intervening government may be forced to bear a burden not caused by the prevailing market conditions in that country.
Another problem associated with the TBTF banks is their indiscipline because of the assurance and expectations that the government will rescue them. Such corporations tend to lack proper managerial and risk mitigation strategies and this escalates the problem of TBTF.
Solutions to the “Too Big to Fail” Issue
Cut down on size
One of the solutions of the TBTF banks is the size of these banks. Most of the large banks have numerous branches both locally and internationally. On the other hand, these branches have wide interconnectedness to the local and foreign businesses. It therefore becomes hard to control the whole bank as one entity. This necessitates that the bank size be reduced. (Meltzer 1) states that, “if a bank is too large to fail”, then it is too big.
He suggests that such banks should be cut down in size so as to reduce their complexities and externalities. In order to reduce the size of megabanks, both radical and incremental measures should be undertaken. One act involves limiting the combinations of commercial banking and investments banking as well as offering insurance underwriting. This was defined by the Glass-Steagall act which separate commercial and investment banking.
These restrictions have however been abolished but reinstating them could serve as a better method of solving the current problem. This separation however may not work well for the systemically important firms. Taxation has also been cited in the articles as another method to cut down on the size of the large banks. The proponents of this idea argue that, if a bank is too big to fail, then it should pay a high tax so as to significantly contribute to the taxpayer’s money in case of its failure.
Increased taxation is also likely to prevent banks from becoming excessively big. Of the failure of large institutions impose a negative externality, then, it should be pay additional capital charges to remedy the negative externality in terms of pigovian tax. Taxations would thus serve as a disincentive to the growth of large banks. However, imposing a huge capital charge on large organizations may act as a deadweight loss as it would directly result to reduced lending and other economic activities in the country.
Another regulatory measure is the Dodd-Frank act which combines a set of restrictions and laws to regulate the TBTF institutions. The law provides regulations for capital requirements, risk assessment method on deposit insurance, the liquidation process as required by FDIC, the Volcker’s rules, tests on financial stress and methods of protecting investors.
One of the regulations imposed by the Dodd –frank act is the abolishment of the financial support that can be given to the large banks. This will definitely result to an end to the TBTF phenomena. This act limits the government intervention should the TBTF banks fail. However, this mechanism prevents only the use of taxpayers’ money but does not prevent the impact the failure of TBTF has on the society in general. This is because the main consequence of the TBTF is the impact it has on the small business.
The Volcker rule is another measure among the Dodd-Frank rule that has been used to prevent the negative impacts of the TBTF. The law enables the creditors to understand that in case of failure, they are eminently going to suffer loses.
The reduction in creditors of the large institutions due to their caution they take due to Dodd-frank would result to limited source of funding and this would enable small banking investment to take advantage. This means that banks that rely on borrowed deposits would have to pay premiums so as to reduce risks imposed on the creditors.
Another law is the stringent measures that have been imposed on the systemically important financial institutions. The Dodd –Frank rule identified these financial institutions and imposes new rules and regulations. These regulations are likely to impose restrictions on the big banks and enable them operate in a more controlled manner.
The Volcker’s rule is the cornerstone of the Dodd-frank rules and was formed as a modern version of the Glass-Steagall rule of 1993 that separated investment banking. The Volcker’s rule bans proprietary trading. This occurs when a bank invests its own funds so as to make profits.
This rule bans banks from one of the most profitable business and most banks argue that this rule cannot prevent financial crisis. Most of the financial institutions indicate that the financial crises resulted from bad management of mortgages and not from insurance banking (Mishkin 4). There is no evidence showing that the financial crises of 2007 were caused by the lack of separation of the banking activities.
The Basel III regulations are also set to reduce the impact of the TBTF banks. The Basel III is a global regulation standard for banks capital. The rules under these regulations seek to improve the quantity and quality of the capital from banks. The proposed rules are that tier I capital will be increased from 4% to 6% , the tier 1 common equity requirement increased from 2% to 4.5 % and a leverage ratio of 3%.
All these measures among others will improve the capital quality and quantity and limit the effects of TBTF (Mishkin 4). In line with these rules are other international rules such as the United Kingdom which is set to adopt ring fencing. Ring fencing as outlined by Sir John Vickers independent commission seeks to separate banking activities from other activities.
The rule indicates that high street banking business should be separated from the investment banking which is more risky. Ring fencing stipulates that there is need to separate the high end banking operations from other banking services. Furthermore, these banks will be required to hold a capital of 10% and 20% when the debt instruments are included.
In culmination, the too big to fail problem results from the interconnectedness that emerge from big financial institutions and other businesses. When big financial institutions fail, they have far reaching economic impact and as a result, government has to bail these institutions. All the articles indicate that it is necessary for appropriate measures to be taken to avert the fail scenario as well as reducing the size of these banks. The articles however criticize the measures taken are ineffective in controlling the impacts of TBTF and other specific measurers need to be undertaken.
Dudley, William. “Solving the Too Big to Fail Problem”. Macro prospective on the capital markets, economy, technology & digital media. 15 Nov 2012:1. Web.
Meltzer, Allan. “End Too-Big-To-Fail.” The Magazine of International Economic Policy. Winter, 2009.
Mishkin, Frederic. “How Big a Problem is Too Big to Fail? A Review of Gary Stern and Ron Feldman’s Too Big to Fail: The Hazards of Bank Bail outs”. Journal of Economic Literature 19.1(2006): 988–1004.