Too Big to Fail

Too Big to Fail
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Too Big to Fail
The colloquial ‘Too Big to Fail’ is a term used particularly to describe some specific financial institutions which are very large and very interconnected such that their failure is widely considered to be disastrous to the nation’s economy, and which therefore, need to be supported by the government in case they face economic difficulty (Sorkin 12). ‘Too Big to Fail’ also refers to the notion that a business has become extensively big/large and ingrained in the country’s economy that the government would provide financial assistance to prevent it from failing. This is because of the belief that if a large company fails, it will definitely have a catastrophic ripple effect throughout the economy. This paper discusses the ‘Too Big to Fail’ problem, and provides some possible remedies for it. It also discusses and compares those possible remedies and identifies which among them is the best. Moreover, the paper describes any recent acts of Congress in helping to remedy the problem.
The problem
The chief cause of the ‘Too Big to Fail’ (TBTF) problem in the United States is the fact that the financial system as it exists currently, the failure of large and complex financial institutions generate large and undesirable externalities. These mainly include disruption/interruption of the stability of the financial system and its ability of providing credit as well as other essential services to businesses and households (Sorkin 23). When this occurs, the financial sector gets disrupted and its troubles flow over into the real economy. There are several negative externalities linked with failure of any financial institution, and they are excessively high in the case of complex, interconnected and large institutions. However, the magnitude/scale of these externalities of does not only depend on size. It also depends on the degree/extent of interconnectedness with the rest of the financial system and the particular mix of business activities. One crucial element is the significance of the services the institution offers to the wider financial system and the economy, and the simplicity with which customers could move their businesses to other providers. The other element is the extent to which the institution’s activities and structures create the potential for contagion – meaning, direct losses for counterparties, and loss of confidence, which could precipitate runs on other financial institutions that have similar business models (Johnson). Usually, the presence of large/big negative externalities will create a dilemma for policy makers when such financial institutions face the danger of failing, especially in the broader financial system is also undergoing stress during that period. At that moment, the anticipated costs to society of failure are so large in relation to the short-run costs from providing/offering liquidity support, capital or any other fiscal emergency assistance necessary to avert disastrous failure. The belief of the market that a TBTF institution has a higher likelihood of being rescued in case of distress compared to other institutions weakens the degree/level of market discipline put forth by counterparties and capital providers. This decreases the institution’s cost of funds and incents it to take more risk than it would have, if funding costs were higher and if there were no rescue prospect (Quirk).
The fact that financial institutions considered by the market as TBTF have the benefit of an artificial subsidy which is in the form of lower funding costs serve to distort the competition to the detriment of less complex and smaller firms. The funding benefit of being deemed TBTF makes the financial system become artificially skewed toward more complex and larger institutions in ways unrelated to factual economies of scale and scope. Firms do not necessarily deliberately aim to be TBTF, and TBTF problem was not the chief cause of the breakdown in the market discipline, which paved the way for the financial crisis. Other factors contributed, for instance the failure to grasp the riskiness of new sorts/kinds of credit products (Isaac and Hurley).
The TBTF problem has become more significant today for different reasons. Chief among them is that the largest financial firms have become much bigger, both in absolute terms as well as relative to the overall size of the financial system. This reflects several factors such as the end of prohibitions on interstate banking, the fast growth of the capital markets, and lastly the globalization of the economy (Isaac and Hurley). These have created strong competitive pressures to expand so as to achieve economies of scale and scope. Secondly, the interconnectedness and complexity of the biggest financial institutions increased significantly. Contributing factors include the quick growth of trading businesses, particularly the over the counter (OTC) derivatives market, and the adoption of a universal banking model by certain commercial bank holding firms (Johnson).
By 2007, there were many universal banks, which combined the traditional/conventional commercial banking and with capital markets as well as underwriting activities. Such firms include J.P. Morgan, Credit Suisse, Citigroup, UBS and Deutsche Bank (Isaac and Hurley). During this time, little attention was paid to the risks that building up within the financial system. In addition, the supervisory and regulatory framework did not keep up with the changes in complexity, size, globalization and interconnectedness that created increasing systemic risk externalities and broadened the wedge between social and private costs in the event of failure (Sorkin 29). The TBTF problem was made worse by the financial crisis as well as the policy response. Being faced with system-wide stress, the Federal Reserve intervened to avert the disorderly failure of Bear Stearns – an institution t...