Too Big to Fail policy
Encyclopedia
"Too big to fail" is a colloquial term in regulation
and public policy
that refers to businesses dealing with market complications related to moral hazard
, macroeconomics
, economic specialization, and monetary theory
.
According to this theory, certain financial institutions are so large and so interconnected that their failure will be disastrous to an economy. Proponents of this theory believe that these institutions should become recipients of beneficial financial and economic policies from governments or central banks to keep them alive. It is thought that companies that fall into this category take positions
that are high-risk, as they are able to leverage these risks based on the policy preference they receive. The term has emerged as prominent in public discourse since the 2007–2010 global financial crisis.
Some critics see the policy as counterproductive and that large banks or other institutions should be left to fail if their risk management is not effective. Moreover, some assert that the "too big to fail" policy has been explicitly refuted in the People's Republic of China
, with the insolvency of Guangdong International Trust & Investment Corporation in 1998.
Some economists, such as Nobel Laureate Paul Krugman
, hold that economy of scale in banks, as in other
businesses, as worth preserving, so long as they are well regulated in proportion to their economic clout, and therefore that "too big to fail" status can be acceptable. The global economic system must also deal with sovereign states being too big to fail. Others, such as Alan Greenspan
, disagree: “If they’re too big to fail, they’re too big”.
experienced a fall in its overall asset quality during the early 1980s. Tight money, Mexico's default and plunging oil prices followed a period when the bank had aggressively pursued commercial lending business, Latin American syndicated loan
business, and loan participations in the energy sector. Complicating matters further, the bank's funding mix was heavily dependent on large CDs
and foreign money market
s, which meant its depositors were more risk-averse than average retail depositors in the US.
. When Penn Square failed in July 1982, the Continental's distress became acute, culminating with press rumors of failure and an investor-and-depositor run
in early May 1984. In the first week of the run, the Fed
permitted the Continental Illinois discount window
credits on the order of $3.6 billion. Still in significant distress, the management obtained a further $4.5 billion in credits from a syndicate of money center banks the following week. These measures failed to stop the run, and regulators were confronted with a crisis.
of the early 1980s, no purchaser was forthcoming.
Besides generic concerns of size, contagion of depositor panic and bank distress, regulators feared the significant disruption of national payment and settlement systems. Of special concern was the wide network of correspondent banks with high percentages of their capital invested in the Continental Illinois. Essentially, the bank was deemed "too big to fail," and the "provide assistance" option was reluctantly taken. The dilemma now became, how to provide assistance without significantly unbalancing the nation's banking system?
, the Federal Reserve announced categorically that it would meet any liquidity needs the Continental might have, while the Federal Deposit Insurance Corporation
(FDIC) gave depositors and general creditors a full guarantee (not subject to the $100,000 FDIC deposit-insurance limit) and provided direct assistance of $2 billion (including participations). Money center banks assembled an additional $5.3 billion unsecured facility pending a resolution and resumption of more-normal business. These measures slowed, but did not stop, the outflow of deposits.
hearing afterwards, the then Comptroller of the Currency C. T. Conover
defended his position by admitting the regulators will not let the largest 11 banks fail. Regulatory agencies (FDIC, Office of the Comptroller of the Currency
, the Federal Reserve System
, etc.) feared this may cause widespread financial complications and a major bank run
that may easily spread by financial contagion. The implicit guarantee of too-big-to-fail has been criticized by many since then for its preferential treatment of large banks. Simultaneously, the perception of too-big-to-fail may diminish healthy market discipline
, and may have influenced the decisions behind the insolvency of Washington Mutual
in 2008. For example, large depositors in banks not covered by the policy tend to have a strong incentive to monitor the bank's financial condition, and/or withdraw in case the bank's policies exposes them to high risks, since FDIC guarantees have an upper limit. However, large depositors in a "too big to fail" bank would have less incentive, since they'd expect to be bailed out in the event of failure.
The Federal Deposit Insurance Corporation Improvement Act
was passed in 1991, giving the FDIC the responsibility to rescue an insolvent bank by the least costly method. The Act had the implicit goal of eliminating the widespread belief among depositors that a loss of depositors and bondholders will be prevented for large banks. However, the Act included an exception in cases of systemic risk, subject to the approval of two-thirds of the FDIC Board of Directors, the Federal Reserve Board of Governors, and the Treasury Secretary.
Ron Suskind
claimed in his book Confidence Men
that the administration of Barack Obama considered breaking up Citibank and other large banks that had been involved in the financial crisis of 2008. Suskind claims that Obama's staff, such as Timothy Geithner, refused to do so. The administration and Geithner have denied this version of events.
"Too big to fail" is a colloquial term in regulation
and public policy
that refers to businesses dealing with market complications related to moral hazard
, macroeconomics
, economic specialization, and monetary theory
.
According to this theory, certain financial institutions are so large and so interconnected that their failure will be disastrous to an economy. Proponents of this theory believe that these institutions should become recipients of beneficial financial and economic policies from governments or central banks to keep them alive.http://www.businessdictionary.com/definition/too-big-to-fail.html It is thought that companies that fall into this category take positions
that are high-risk, as they are able to leverage these risks based on the policy preference they receive.Federal Reserve Bank of Richmond Economic Quarterly Volume 91/2 Spring 2005 by Ennis, Huberto M.; Malek, H.S The term has emerged as prominent in public discourse since the 2007–2010 global financial crisis.Turner, Adair. "Too Much 'Too Big to Fail'?" Economist's View. September 2, 2010.
Some critics see the policy as counterproductive and that large banks or other institutions should be left to fail if their risk management is not effective.Alton E. Drew, The Business Week, http://www.businessweek.com/bwdaily/dnflash/content/feb2009/db20090218_166676.htm retrieved on March 20, 2009 Moreover, some assert that the "too big to fail" policy has been explicitly refuted in the People's Republic of China
, with the insolvency of Guangdong International Trust & Investment Corporation in 1998.
Some economists, such as Nobel Laureate Paul Krugman
, hold that economy of scale in banks, as in other
businesses, as worth preserving, so long as they are well regulated in proportion to their economic clout, and therefore that "too big to fail" status can be acceptable. The global economic system must also deal with sovereign states being too big to fail.Paul Krugman "Financial Reform 101" April 1, 2010Paul Krugman "Stop 'Stop Too Big To Fail'." April 21, 2010Paul Krugman "Too big to fail FAIL" June 18, 2009Paul Krugman "A bit more on too big to fail and related" June 19, 2009 Others, such as Alan Greenspan
, disagree: “If they’re too big to fail, they’re too big”.
experienced a fall in its overall asset quality during the early 1980s. Tight money, Mexico's default and plunging oil prices followed a period when the bank had aggressively pursued commercial lending business, Latin American syndicated loan
business, and loan participations in the energy sector. Complicating matters further, the bank's funding mix was heavily dependent on large CDs
and foreign money market
s, which meant its depositors were more risk-averse than average retail depositors in the US.
Belly Up, Phillip Zweig, Ballantine Books, 1986. When Penn Square failed in July 1982, the Continental's distress became acute, culminating with press rumors of failure and an investor-and-depositor run
in early May 1984. In the first week of the run, the Fed
permitted the Continental Illinois discount window
credits on the order of $3.6 billion. Still in significant distress, the management obtained a further $4.5 billion in credits from a syndicate of money center banks the following week. These measures failed to stop the run, and regulators were confronted with a crisis.
of the early 1980s, no purchaser was forthcoming.
Besides generic concerns of size, contagion of depositor panic and bank distress, regulators feared the significant disruption of national payment and settlement systems. Of special concern was the wide network of correspondent banks with high percentages of their capital invested in the Continental Illinois. Essentially, the bank was deemed "too big to fail," and the "provide assistance" option was reluctantly taken. The dilemma now became, how to provide assistance without significantly unbalancing the nation's banking system?
, the Federal Reserve announced categorically that it would meet any liquidity needs the Continental might have, while the Federal Deposit Insurance Corporation
(FDIC) gave depositors and general creditors a full guarantee (not subject to the $100,000 FDIC deposit-insurance limit) and provided direct assistance of $2 billion (including participations). Money center banks assembled an additional $5.3 billion unsecured facility pending a resolution and resumption of more-normal business. These measures slowed, but did not stop, the outflow of deposits.
hearing afterwards, the then Comptroller of the Currency C. T. Conover
defended his position by admitting the regulators will not let the largest 11 banks fail. Regulatory agencies (FDIC, Office of the Comptroller of the Currency
, the Federal Reserve System
, etc.) feared this may cause widespread financial complications and a major bank run
that may easily spread by financial contagion. The implicit guarantee of too-big-to-fail has been criticized by many since then for its preferential treatment of large banks. Simultaneously, the perception of too-big-to-fail may diminish healthy market discipline
, and may have influenced the decisions behind the insolvency of Washington Mutual
in 2008. For example, large depositors in banks not covered by the policy tend to have a strong incentive to monitor the bank's financial condition, and/or withdraw in case the bank's policies exposes them to high risks, since FDIC guarantees have an upper limit. However, large depositors in a "too big to fail" bank would have less incentive, since they'd expect to be bailed out in the event of failure.
The Federal Deposit Insurance Corporation Improvement Act
was passed in 1991, giving the FDIC the responsibility to rescue an insolvent bank by the least costly method. The Act had the implicit goal of eliminating the widespread belief among depositors that a loss of depositors and bondholders will be prevented for large banks. However, the Act included an exception in cases of systemic risk, subject to the approval of two-thirds of the FDIC Board of Directors, the Federal Reserve Board of Governors, and the Treasury Secretary.
Ron Suskind
claimed in his book Confidence Men
that the administration of Barack Obama considered breaking up Citibank and other large banks that had been involved in the financial crisis of 2008. Suskind claims that Obama's staff, such as Timothy Geithner, refused to do so. The administration and Geithner have denied this version of events. Book Details Dissension in Obama Economic Team, by MARK LANDLER, New York Times, September 15, 2011
"Too big to fail" is a colloquial term in regulation
and public policy
that refers to businesses dealing with market complications related to moral hazard
, macroeconomics
, economic specialization, and monetary theory
.
According to this theory, certain financial institutions are so large and so interconnected that their failure will be disastrous to an economy. Proponents of this theory believe that these institutions should become recipients of beneficial financial and economic policies from governments or central banks to keep them alive.http://www.businessdictionary.com/definition/too-big-to-fail.html It is thought that companies that fall into this category take positions
that are high-risk, as they are able to leverage these risks based on the policy preference they receive.Federal Reserve Bank of Richmond Economic Quarterly Volume 91/2 Spring 2005 by Ennis, Huberto M.; Malek, H.S The term has emerged as prominent in public discourse since the 2007–2010 global financial crisis.Turner, Adair. "Too Much 'Too Big to Fail'?" Economist's View. September 2, 2010.
Some critics see the policy as counterproductive and that large banks or other institutions should be left to fail if their risk management is not effective.Alton E. Drew, The Business Week, http://www.businessweek.com/bwdaily/dnflash/content/feb2009/db20090218_166676.htm retrieved on March 20, 2009 Moreover, some assert that the "too big to fail" policy has been explicitly refuted in the People's Republic of China
, with the insolvency of Guangdong International Trust & Investment Corporation in 1998.
Some economists, such as Nobel Laureate Paul Krugman
, hold that economy of scale in banks, as in other
businesses, as worth preserving, so long as they are well regulated in proportion to their economic clout, and therefore that "too big to fail" status can be acceptable. The global economic system must also deal with sovereign states being too big to fail.Paul Krugman "Financial Reform 101" April 1, 2010Paul Krugman "Stop 'Stop Too Big To Fail'." April 21, 2010Paul Krugman "Too big to fail FAIL" June 18, 2009Paul Krugman "A bit more on too big to fail and related" June 19, 2009 Others, such as Alan Greenspan
, disagree: “If they’re too big to fail, they’re too big”.
experienced a fall in its overall asset quality during the early 1980s. Tight money, Mexico's default and plunging oil prices followed a period when the bank had aggressively pursued commercial lending business, Latin American syndicated loan
business, and loan participations in the energy sector. Complicating matters further, the bank's funding mix was heavily dependent on large CDs
and foreign money market
s, which meant its depositors were more risk-averse than average retail depositors in the US.
Belly Up, Phillip Zweig, Ballantine Books, 1986. When Penn Square failed in July 1982, the Continental's distress became acute, culminating with press rumors of failure and an investor-and-depositor run
in early May 1984. In the first week of the run, the Fed
permitted the Continental Illinois discount window
credits on the order of $3.6 billion. Still in significant distress, the management obtained a further $4.5 billion in credits from a syndicate of money center banks the following week. These measures failed to stop the run, and regulators were confronted with a crisis.
of the early 1980s, no purchaser was forthcoming.
Besides generic concerns of size, contagion of depositor panic and bank distress, regulators feared the significant disruption of national payment and settlement systems. Of special concern was the wide network of correspondent banks with high percentages of their capital invested in the Continental Illinois. Essentially, the bank was deemed "too big to fail," and the "provide assistance" option was reluctantly taken. The dilemma now became, how to provide assistance without significantly unbalancing the nation's banking system?
, the Federal Reserve announced categorically that it would meet any liquidity needs the Continental might have, while the Federal Deposit Insurance Corporation
(FDIC) gave depositors and general creditors a full guarantee (not subject to the $100,000 FDIC deposit-insurance limit) and provided direct assistance of $2 billion (including participations). Money center banks assembled an additional $5.3 billion unsecured facility pending a resolution and resumption of more-normal business. These measures slowed, but did not stop, the outflow of deposits.
hearing afterwards, the then Comptroller of the Currency C. T. Conover
defended his position by admitting the regulators will not let the largest 11 banks fail. Regulatory agencies (FDIC, Office of the Comptroller of the Currency
, the Federal Reserve System
, etc.) feared this may cause widespread financial complications and a major bank run
that may easily spread by financial contagion. The implicit guarantee of too-big-to-fail has been criticized by many since then for its preferential treatment of large banks. Simultaneously, the perception of too-big-to-fail may diminish healthy market discipline
, and may have influenced the decisions behind the insolvency of Washington Mutual
in 2008. For example, large depositors in banks not covered by the policy tend to have a strong incentive to monitor the bank's financial condition, and/or withdraw in case the bank's policies exposes them to high risks, since FDIC guarantees have an upper limit. However, large depositors in a "too big to fail" bank would have less incentive, since they'd expect to be bailed out in the event of failure.
The Federal Deposit Insurance Corporation Improvement Act
was passed in 1991, giving the FDIC the responsibility to rescue an insolvent bank by the least costly method. The Act had the implicit goal of eliminating the widespread belief among depositors that a loss of depositors and bondholders will be prevented for large banks. However, the Act included an exception in cases of systemic risk, subject to the approval of two-thirds of the FDIC Board of Directors, the Federal Reserve Board of Governors, and the Treasury Secretary.
Ron Suskind
claimed in his book Confidence Men
that the administration of Barack Obama considered breaking up Citibank and other large banks that had been involved in the financial crisis of 2008. Suskind claims that Obama's staff, such as Timothy Geithner, refused to do so. The administration and Geithner have denied this version of events. Book Details Dissension in Obama Economic Team, by MARK LANDLER, New York Times, September 15, 2011Geithner denies ignoring Obama's request on banks Associated Press, via CBSnews.com, September 19, 2011 2:31 PM
found that the difference between the cost of funds
for banks with more than $100 billion in assets and the cost of funds for smaller banks widened dramatically after the formalization of the "too big to fail" policy in the U.S. in the fourth quarter of 2008. This shift in the large banks' cost of funds was in effect equivalent to an indirect "too big to fail" subsidy of $34.1 billion per year to the 18 U.S. banks with more than $100 billion in assets.
, the governor of the Bank of England
, called for banks that are "too big to fail" to be cut down to size, as a solution to the problem of banks having taxpayer-funded guarantees for their speculative investment banking activities. "If some banks are thought to be too big to fail, then, in the words of a distinguished American economist, they are too big. It is not sensible to allow large banks to combine high street retail banking with risky investment banking or funding strategies, and then provide an implicit state guarantee against failure." However, Alistair Darling
disagreed; "Many people talk about how to deal with the big banks – banks so important to the financial system that they cannot be allowed to fail. But the solution is not as simple, as some have suggested, as restricting the size of the banks".
As well, Alan Greenspan
said that “If they’re too big to fail, they’re too big,” suggesting U.S. regulators to consider breaking up large financial institutions considered “too big to fail.” He added, “I don’t think merely raising the fees or capital on large institutions or taxing them is enough ... they’ll absorb that, they’ll work with that, and it’s totally inefficient and they’ll still be using the savings.”
proposes a tax to internalize the massive external costs inflicted by "too big to fail" institution. "When size creates externalities, do what you would do with any negative externality: tax it. The other way to limit size is to tax size. This can be done through capital requirements that are progressive in the size of the business (as measured by value added, the size of the balance sheet or some other metric). Such measures for preventing the New Darwinism of the survival of the fittest and the politically best connected should be distinguished from regulatory interventions based on the narrow leverage ratio aimed at regulating risk (regardless of size, except for a de minimis lower limit)."
released a list of
29 banks worldwide that they considered to be "too big to fail". Of the
list, 17 banks are based in Europe, 8 in the U.S., and the other four in Asia:
Regulatory economics
Regulatory economics is the economics of regulation, in the sense of the application of law by government that is used for various purposes, such as centrally-planning an economy, remedying market failure, enriching well-connected firms, or benefiting politicians...
and public policy
Public policy
Public policy as government action is generally the principled guide to action taken by the administrative or executive branches of the state with regard to a class of issues in a manner consistent with law and institutional customs. In general, the foundation is the pertinent national and...
that refers to businesses dealing with market complications related to moral hazard
Moral hazard
In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...
, macroeconomics
Macroeconomics
Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy...
, economic specialization, and monetary theory
Monetary theory
Monetary economics is a branch of economics that historically prefigured and remains integrally linked to macroeconomics. Monetary economics provides a framework for analyzing money in its functions as a medium of exchange, store of value, and unit of account. It considers how money, for example...
.
According to this theory, certain financial institutions are so large and so interconnected that their failure will be disastrous to an economy. Proponents of this theory believe that these institutions should become recipients of beneficial financial and economic policies from governments or central banks to keep them alive. It is thought that companies that fall into this category take positions
Asset allocation
Asset allocation is an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investors risk tolerance, goals and investment time frame.-Description:...
that are high-risk, as they are able to leverage these risks based on the policy preference they receive. The term has emerged as prominent in public discourse since the 2007–2010 global financial crisis.
Some critics see the policy as counterproductive and that large banks or other institutions should be left to fail if their risk management is not effective. Moreover, some assert that the "too big to fail" policy has been explicitly refuted in the People's Republic of China
People's Republic of China
China , officially the People's Republic of China , is the most populous country in the world, with over 1.3 billion citizens. Located in East Asia, the country covers approximately 9.6 million square kilometres...
, with the insolvency of Guangdong International Trust & Investment Corporation in 1998.
Some economists, such as Nobel Laureate Paul Krugman
Paul Krugman
Paul Robin Krugman is an American economist, professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times...
, hold that economy of scale in banks, as in other
businesses, as worth preserving, so long as they are well regulated in proportion to their economic clout, and therefore that "too big to fail" status can be acceptable. The global economic system must also deal with sovereign states being too big to fail. Others, such as Alan Greenspan
Alan Greenspan
Alan Greenspan is an American economist who served as Chairman of the Federal Reserve of the United States from 1987 to 2006. He currently works as a private advisor and provides consulting for firms through his company, Greenspan Associates LLC...
, disagree: “If they’re too big to fail, they’re too big”.
Regulatory basis
Before 1950, U.S. federal bank regulators had essentially two options for resolving an insolvent institution: closure, with liquidation of assets and payouts for insured depositors, or purchase and assumption, encouraging the acquisition of assets and assumption of liabilities by another firm. A third option was made available by the Federal Deposit Insurance Act of 1950: providing assistance, the power to support an institution through loans or direct federal acquisition of assets, until it could recover from its distress. The statute limited the "assistance" option to cases where "continued operation of the bank is essential to provide adequate banking service." Regulators shunned this third option for many years, fearing that if regionally or nationally important banks were thought to be generally immune to liquidation, markets in their shares would be distorted. Thus, the assistance option was never employed during the period 1950-1969, and very seldom thereafter.Distress
The Continental Illinois National Bank and Trust CompanyContinental Illinois National Bank and Trust Company
The Continental Illinois National Bank and Trust Company was at one time the seventh-largest bank in the United States as measured by deposits with approximately $40 billion in assets. In 1984, Continental Illinois became the largest ever bank failure in U.S. history, when a run on the bank led to...
experienced a fall in its overall asset quality during the early 1980s. Tight money, Mexico's default and plunging oil prices followed a period when the bank had aggressively pursued commercial lending business, Latin American syndicated loan
Syndicated loan
A syndicated loan is one that is provided by a group of lenders and is structured, arranged, and administered by one or several commercial banks or investment banks known as arrangers....
business, and loan participations in the energy sector. Complicating matters further, the bank's funding mix was heavily dependent on large CDs
Certificate of deposit
A certificate of Deposit is a time deposit, a financial product commonly offered to consumers in the United States by banks, thrift institutions, and credit unions....
and foreign money market
Money market
The money market is a component of the financial markets for assets involved in short-term borrowing and lending with original maturities of one year or shorter time frames. Trading in the money markets involves Treasury bills, commercial paper, bankers' acceptances, certificates of deposit,...
s, which meant its depositors were more risk-averse than average retail depositors in the US.
Payments crisis
The bank held significant participation in highly-speculative oil and gas loans of Oklahoma's Penn Square BankPenn Square Bank
Penn Square Bank was a small commercial bank located in the rear of the Penn Square Mall in Oklahoma City. The bank made its name in high-risk energy loans during the late 1970s and early 1980s Oklahoma and Texas oil boom. Between 1974 and 1982, the bank's assets increased more than 15 times to...
. When Penn Square failed in July 1982, the Continental's distress became acute, culminating with press rumors of failure and an investor-and-depositor run
Bank run
A bank run occurs when a large number of bank customers withdraw their deposits because they believe the bank is, or might become, insolvent...
in early May 1984. In the first week of the run, the Fed
Federal Reserve System
The Federal Reserve System is the central banking system of the United States. It was created on December 23, 1913 with the enactment of the Federal Reserve Act, largely in response to a series of financial panics, particularly a severe panic in 1907...
permitted the Continental Illinois discount window
Discount window
The discount window is an instrument of monetary policy that allows eligible institutions to borrow money from the central bank, usually on a short-term basis, to meet temporary shortages of liquidity caused by internal or external disruptions...
credits on the order of $3.6 billion. Still in significant distress, the management obtained a further $4.5 billion in credits from a syndicate of money center banks the following week. These measures failed to stop the run, and regulators were confronted with a crisis.
Regulatory crisis
The seventh-largest bank in the nation by deposits would very shortly be unable to meet its obligations. Regulators faced a tough decision about how to resolve the matter. Of the three options available, only two were seriously considered. Even banks much smaller than the Continental were deemed unsuitable for resolution by liquidation, owing to the disruptions this would have inevitably caused. The normal course would be to seek a purchaser (and indeed press accounts that such a search was underway contributed to Continental depositors' fears in 1984). However, in the tight-money financial climateEarly 1980s recession
The early 1980s recession describes the severe global economic recession affecting much of the developed world in the late 1970s and early 1980s. The United States and Japan exited recession relatively early, but high unemployment would continue to affect other OECD nations through at least 1985...
of the early 1980s, no purchaser was forthcoming.
Besides generic concerns of size, contagion of depositor panic and bank distress, regulators feared the significant disruption of national payment and settlement systems. Of special concern was the wide network of correspondent banks with high percentages of their capital invested in the Continental Illinois. Essentially, the bank was deemed "too big to fail," and the "provide assistance" option was reluctantly taken. The dilemma now became, how to provide assistance without significantly unbalancing the nation's banking system?
Stopping the run
To prevent immediate failureInsolvency
Insolvency means the inability to pay one's debts as they fall due. Usually used to refer to a business, insolvency refers to the inability of a company to pay off its debts.Business insolvency is defined in two different ways:...
, the Federal Reserve announced categorically that it would meet any liquidity needs the Continental might have, while the Federal Deposit Insurance Corporation
Federal Deposit Insurance Corporation
The Federal Deposit Insurance Corporation is a United States government corporation created by the Glass–Steagall Act of 1933. It provides deposit insurance, which guarantees the safety of deposits in member banks, currently up to $250,000 per depositor per bank. , the FDIC insures deposits at...
(FDIC) gave depositors and general creditors a full guarantee (not subject to the $100,000 FDIC deposit-insurance limit) and provided direct assistance of $2 billion (including participations). Money center banks assembled an additional $5.3 billion unsecured facility pending a resolution and resumption of more-normal business. These measures slowed, but did not stop, the outflow of deposits.
Controversy
In a United States SenateUnited States Senate
The United States Senate is the upper house of the bicameral legislature of the United States, and together with the United States House of Representatives comprises the United States Congress. The composition and powers of the Senate are established in Article One of the U.S. Constitution. Each...
hearing afterwards, the then Comptroller of the Currency C. T. Conover
C. T. Conover
Todd C. Conover was Comptroller of the Currency in the United States from 1981 to 1985 Conover, a California banking and management consultant, was named Comptroller by President Ronald Reagan...
defended his position by admitting the regulators will not let the largest 11 banks fail. Regulatory agencies (FDIC, Office of the Comptroller of the Currency
Office of the Comptroller of the Currency
The Office of the Comptroller of the Currency is a US federal agency established by the National Currency Act of 1863 and serves to charter, regulate, and supervise all national banks and the federal branches and agencies of foreign banks in the United States...
, the Federal Reserve System
Federal Reserve System
The Federal Reserve System is the central banking system of the United States. It was created on December 23, 1913 with the enactment of the Federal Reserve Act, largely in response to a series of financial panics, particularly a severe panic in 1907...
, etc.) feared this may cause widespread financial complications and a major bank run
Bank run
A bank run occurs when a large number of bank customers withdraw their deposits because they believe the bank is, or might become, insolvent...
that may easily spread by financial contagion. The implicit guarantee of too-big-to-fail has been criticized by many since then for its preferential treatment of large banks. Simultaneously, the perception of too-big-to-fail may diminish healthy market discipline
Market discipline
Buyers and sellers in a market are said to be constrained by market discipline in setting prices because they have strong incentives to generate revenues and avoid bankruptcy...
, and may have influenced the decisions behind the insolvency of Washington Mutual
Washington Mutual
Washington Mutual, Inc. , abbreviated to WaMu, was a savings bank holding company and the former owner of Washington Mutual Bank, which was the United States' largest savings and loan association until its collapse in 2008....
in 2008. For example, large depositors in banks not covered by the policy tend to have a strong incentive to monitor the bank's financial condition, and/or withdraw in case the bank's policies exposes them to high risks, since FDIC guarantees have an upper limit. However, large depositors in a "too big to fail" bank would have less incentive, since they'd expect to be bailed out in the event of failure.
The Federal Deposit Insurance Corporation Improvement Act
Federal Deposit Insurance Corporation Improvement Act of 1991
The Federal Deposit Insurance Corporation Improvement Act of 1991 , passed during the Savings and loan crisis, strengthened the power of the Federal Deposit Insurance Corporation....
was passed in 1991, giving the FDIC the responsibility to rescue an insolvent bank by the least costly method. The Act had the implicit goal of eliminating the widespread belief among depositors that a loss of depositors and bondholders will be prevented for large banks. However, the Act included an exception in cases of systemic risk, subject to the approval of two-thirds of the FDIC Board of Directors, the Federal Reserve Board of Governors, and the Treasury Secretary.
Ron Suskind
Ron Suskind
Ron Suskind is a Pulitzer Prize winning American journalist and best-selling author. He was the senior national affairs writer for The Wall Street Journal from 1993 to 2000 and has published the books A Hope in the Unseen, The Price of Loyalty, The One Percent Doctrine, The Way of the World and...
claimed in his book Confidence Men
Confidence Men
Confidence Men: Wall Street, Washington and the Education of a President is a book by Ron Suskind, published by HarperCollins on September 20, 2011....
that the administration of Barack Obama considered breaking up Citibank and other large banks that had been involved in the financial crisis of 2008. Suskind claims that Obama's staff, such as Timothy Geithner, refused to do so. The administration and Geithner have denied this version of events.
"Too big to fail" is a colloquial term in regulation
Regulatory economics
Regulatory economics is the economics of regulation, in the sense of the application of law by government that is used for various purposes, such as centrally-planning an economy, remedying market failure, enriching well-connected firms, or benefiting politicians...
and public policy
Public policy
Public policy as government action is generally the principled guide to action taken by the administrative or executive branches of the state with regard to a class of issues in a manner consistent with law and institutional customs. In general, the foundation is the pertinent national and...
that refers to businesses dealing with market complications related to moral hazard
Moral hazard
In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...
, macroeconomics
Macroeconomics
Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy...
, economic specialization, and monetary theory
Monetary theory
Monetary economics is a branch of economics that historically prefigured and remains integrally linked to macroeconomics. Monetary economics provides a framework for analyzing money in its functions as a medium of exchange, store of value, and unit of account. It considers how money, for example...
.
According to this theory, certain financial institutions are so large and so interconnected that their failure will be disastrous to an economy. Proponents of this theory believe that these institutions should become recipients of beneficial financial and economic policies from governments or central banks to keep them alive.http://www.businessdictionary.com/definition/too-big-to-fail.html It is thought that companies that fall into this category take positions
Asset allocation
Asset allocation is an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investors risk tolerance, goals and investment time frame.-Description:...
that are high-risk, as they are able to leverage these risks based on the policy preference they receive.Federal Reserve Bank of Richmond Economic Quarterly Volume 91/2 Spring 2005 by Ennis, Huberto M.; Malek, H.S The term has emerged as prominent in public discourse since the 2007–2010 global financial crisis.Turner, Adair. "Too Much 'Too Big to Fail'?" Economist's View. September 2, 2010.
Some critics see the policy as counterproductive and that large banks or other institutions should be left to fail if their risk management is not effective.Alton E. Drew, The Business Week, http://www.businessweek.com/bwdaily/dnflash/content/feb2009/db20090218_166676.htm retrieved on March 20, 2009 Moreover, some assert that the "too big to fail" policy has been explicitly refuted in the People's Republic of China
People's Republic of China
China , officially the People's Republic of China , is the most populous country in the world, with over 1.3 billion citizens. Located in East Asia, the country covers approximately 9.6 million square kilometres...
, with the insolvency of Guangdong International Trust & Investment Corporation in 1998.
Some economists, such as Nobel Laureate Paul Krugman
Paul Krugman
Paul Robin Krugman is an American economist, professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times...
, hold that economy of scale in banks, as in other
businesses, as worth preserving, so long as they are well regulated in proportion to their economic clout, and therefore that "too big to fail" status can be acceptable. The global economic system must also deal with sovereign states being too big to fail.Paul Krugman "Financial Reform 101" April 1, 2010Paul Krugman "Stop 'Stop Too Big To Fail'." April 21, 2010Paul Krugman "Too big to fail FAIL" June 18, 2009Paul Krugman "A bit more on too big to fail and related" June 19, 2009 Others, such as Alan Greenspan
Alan Greenspan
Alan Greenspan is an American economist who served as Chairman of the Federal Reserve of the United States from 1987 to 2006. He currently works as a private advisor and provides consulting for firms through his company, Greenspan Associates LLC...
, disagree: “If they’re too big to fail, they’re too big”.
Regulatory basis
Before 1950, U.S. federal bank regulators had essentially two options for resolving an insolvent institution: closure, with liquidation of assets and payouts for insured depositors, or purchase and assumption, encouraging the acquisition of assets and assumption of liabilities by another firm. A third option was made available by the Federal Deposit Insurance Act of 1950: providing assistance, the power to support an institution through loans or direct federal acquisition of assets, until it could recover from its distress. The statute limited the "assistance" option to cases where "continued operation of the bank is essential to provide adequate banking service." Regulators shunned this third option for many years, fearing that if regionally or nationally important banks were thought to be generally immune to liquidation, markets in their shares would be distorted. Thus, the assistance option was never employed during the period 1950-1969, and very seldom thereafter.http://marriottschool.byu.edu/emp/HBH/mba624/Commercial%20Banking%20Regulation.pdf Heaton, Hal B., Riegger, Christopher. "Commercial Banking Regulation", Class discussion notes.Distress
The Continental Illinois National Bank and Trust CompanyContinental Illinois National Bank and Trust Company
The Continental Illinois National Bank and Trust Company was at one time the seventh-largest bank in the United States as measured by deposits with approximately $40 billion in assets. In 1984, Continental Illinois became the largest ever bank failure in U.S. history, when a run on the bank led to...
experienced a fall in its overall asset quality during the early 1980s. Tight money, Mexico's default and plunging oil prices followed a period when the bank had aggressively pursued commercial lending business, Latin American syndicated loan
Syndicated loan
A syndicated loan is one that is provided by a group of lenders and is structured, arranged, and administered by one or several commercial banks or investment banks known as arrangers....
business, and loan participations in the energy sector. Complicating matters further, the bank's funding mix was heavily dependent on large CDs
Certificate of deposit
A certificate of Deposit is a time deposit, a financial product commonly offered to consumers in the United States by banks, thrift institutions, and credit unions....
and foreign money market
Money market
The money market is a component of the financial markets for assets involved in short-term borrowing and lending with original maturities of one year or shorter time frames. Trading in the money markets involves Treasury bills, commercial paper, bankers' acceptances, certificates of deposit,...
s, which meant its depositors were more risk-averse than average retail depositors in the US.
Payments crisis
The bank held significant participation in highly-speculative oil and gas loans of Oklahoma's Penn Square BankPenn Square Bank
Penn Square Bank was a small commercial bank located in the rear of the Penn Square Mall in Oklahoma City. The bank made its name in high-risk energy loans during the late 1970s and early 1980s Oklahoma and Texas oil boom. Between 1974 and 1982, the bank's assets increased more than 15 times to...
Belly Up, Phillip Zweig, Ballantine Books, 1986. When Penn Square failed in July 1982, the Continental's distress became acute, culminating with press rumors of failure and an investor-and-depositor run
Bank run
A bank run occurs when a large number of bank customers withdraw their deposits because they believe the bank is, or might become, insolvent...
in early May 1984. In the first week of the run, the Fed
Federal Reserve System
The Federal Reserve System is the central banking system of the United States. It was created on December 23, 1913 with the enactment of the Federal Reserve Act, largely in response to a series of financial panics, particularly a severe panic in 1907...
permitted the Continental Illinois discount window
Discount window
The discount window is an instrument of monetary policy that allows eligible institutions to borrow money from the central bank, usually on a short-term basis, to meet temporary shortages of liquidity caused by internal or external disruptions...
credits on the order of $3.6 billion. Still in significant distress, the management obtained a further $4.5 billion in credits from a syndicate of money center banks the following week. These measures failed to stop the run, and regulators were confronted with a crisis.
Regulatory crisis
The seventh-largest bank in the nation by deposits would very shortly be unable to meet its obligations. Regulators faced a tough decision about how to resolve the matter. Of the three options available, only two were seriously considered. Even banks much smaller than the Continental were deemed unsuitable for resolution by liquidation, owing to the disruptions this would have inevitably caused. The normal course would be to seek a purchaser (and indeed press accounts that such a search was underway contributed to Continental depositors' fears in 1984). However, in the tight-money financial climateEarly 1980s recession
The early 1980s recession describes the severe global economic recession affecting much of the developed world in the late 1970s and early 1980s. The United States and Japan exited recession relatively early, but high unemployment would continue to affect other OECD nations through at least 1985...
of the early 1980s, no purchaser was forthcoming.
Besides generic concerns of size, contagion of depositor panic and bank distress, regulators feared the significant disruption of national payment and settlement systems. Of special concern was the wide network of correspondent banks with high percentages of their capital invested in the Continental Illinois. Essentially, the bank was deemed "too big to fail," and the "provide assistance" option was reluctantly taken. The dilemma now became, how to provide assistance without significantly unbalancing the nation's banking system?
Stopping the run
To prevent immediate failureInsolvency
Insolvency means the inability to pay one's debts as they fall due. Usually used to refer to a business, insolvency refers to the inability of a company to pay off its debts.Business insolvency is defined in two different ways:...
, the Federal Reserve announced categorically that it would meet any liquidity needs the Continental might have, while the Federal Deposit Insurance Corporation
Federal Deposit Insurance Corporation
The Federal Deposit Insurance Corporation is a United States government corporation created by the Glass–Steagall Act of 1933. It provides deposit insurance, which guarantees the safety of deposits in member banks, currently up to $250,000 per depositor per bank. , the FDIC insures deposits at...
(FDIC) gave depositors and general creditors a full guarantee (not subject to the $100,000 FDIC deposit-insurance limit) and provided direct assistance of $2 billion (including participations). Money center banks assembled an additional $5.3 billion unsecured facility pending a resolution and resumption of more-normal business. These measures slowed, but did not stop, the outflow of deposits.
Controversy
In a United States SenateUnited States Senate
The United States Senate is the upper house of the bicameral legislature of the United States, and together with the United States House of Representatives comprises the United States Congress. The composition and powers of the Senate are established in Article One of the U.S. Constitution. Each...
hearing afterwards, the then Comptroller of the Currency C. T. Conover
C. T. Conover
Todd C. Conover was Comptroller of the Currency in the United States from 1981 to 1985 Conover, a California banking and management consultant, was named Comptroller by President Ronald Reagan...
defended his position by admitting the regulators will not let the largest 11 banks fail. Regulatory agencies (FDIC, Office of the Comptroller of the Currency
Office of the Comptroller of the Currency
The Office of the Comptroller of the Currency is a US federal agency established by the National Currency Act of 1863 and serves to charter, regulate, and supervise all national banks and the federal branches and agencies of foreign banks in the United States...
, the Federal Reserve System
Federal Reserve System
The Federal Reserve System is the central banking system of the United States. It was created on December 23, 1913 with the enactment of the Federal Reserve Act, largely in response to a series of financial panics, particularly a severe panic in 1907...
, etc.) feared this may cause widespread financial complications and a major bank run
Bank run
A bank run occurs when a large number of bank customers withdraw their deposits because they believe the bank is, or might become, insolvent...
that may easily spread by financial contagion. The implicit guarantee of too-big-to-fail has been criticized by many since then for its preferential treatment of large banks. Simultaneously, the perception of too-big-to-fail may diminish healthy market discipline
Market discipline
Buyers and sellers in a market are said to be constrained by market discipline in setting prices because they have strong incentives to generate revenues and avoid bankruptcy...
, and may have influenced the decisions behind the insolvency of Washington Mutual
Washington Mutual
Washington Mutual, Inc. , abbreviated to WaMu, was a savings bank holding company and the former owner of Washington Mutual Bank, which was the United States' largest savings and loan association until its collapse in 2008....
in 2008. For example, large depositors in banks not covered by the policy tend to have a strong incentive to monitor the bank's financial condition, and/or withdraw in case the bank's policies exposes them to high risks, since FDIC guarantees have an upper limit. However, large depositors in a "too big to fail" bank would have less incentive, since they'd expect to be bailed out in the event of failure.
The Federal Deposit Insurance Corporation Improvement Act
Federal Deposit Insurance Corporation Improvement Act of 1991
The Federal Deposit Insurance Corporation Improvement Act of 1991 , passed during the Savings and loan crisis, strengthened the power of the Federal Deposit Insurance Corporation....
was passed in 1991, giving the FDIC the responsibility to rescue an insolvent bank by the least costly method. The Act had the implicit goal of eliminating the widespread belief among depositors that a loss of depositors and bondholders will be prevented for large banks. However, the Act included an exception in cases of systemic risk, subject to the approval of two-thirds of the FDIC Board of Directors, the Federal Reserve Board of Governors, and the Treasury Secretary.
Ron Suskind
Ron Suskind
Ron Suskind is a Pulitzer Prize winning American journalist and best-selling author. He was the senior national affairs writer for The Wall Street Journal from 1993 to 2000 and has published the books A Hope in the Unseen, The Price of Loyalty, The One Percent Doctrine, The Way of the World and...
claimed in his book Confidence Men
Confidence Men
Confidence Men: Wall Street, Washington and the Education of a President is a book by Ron Suskind, published by HarperCollins on September 20, 2011....
that the administration of Barack Obama considered breaking up Citibank and other large banks that had been involved in the financial crisis of 2008. Suskind claims that Obama's staff, such as Timothy Geithner, refused to do so. The administration and Geithner have denied this version of events. Book Details Dissension in Obama Economic Team, by MARK LANDLER, New York Times, September 15, 2011
"Too big to fail" is a colloquial term in regulation
Regulatory economics
Regulatory economics is the economics of regulation, in the sense of the application of law by government that is used for various purposes, such as centrally-planning an economy, remedying market failure, enriching well-connected firms, or benefiting politicians...
and public policy
Public policy
Public policy as government action is generally the principled guide to action taken by the administrative or executive branches of the state with regard to a class of issues in a manner consistent with law and institutional customs. In general, the foundation is the pertinent national and...
that refers to businesses dealing with market complications related to moral hazard
Moral hazard
In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...
, macroeconomics
Macroeconomics
Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy...
, economic specialization, and monetary theory
Monetary theory
Monetary economics is a branch of economics that historically prefigured and remains integrally linked to macroeconomics. Monetary economics provides a framework for analyzing money in its functions as a medium of exchange, store of value, and unit of account. It considers how money, for example...
.
According to this theory, certain financial institutions are so large and so interconnected that their failure will be disastrous to an economy. Proponents of this theory believe that these institutions should become recipients of beneficial financial and economic policies from governments or central banks to keep them alive.http://www.businessdictionary.com/definition/too-big-to-fail.html It is thought that companies that fall into this category take positions
Asset allocation
Asset allocation is an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investors risk tolerance, goals and investment time frame.-Description:...
that are high-risk, as they are able to leverage these risks based on the policy preference they receive.Federal Reserve Bank of Richmond Economic Quarterly Volume 91/2 Spring 2005 by Ennis, Huberto M.; Malek, H.S The term has emerged as prominent in public discourse since the 2007–2010 global financial crisis.Turner, Adair. "Too Much 'Too Big to Fail'?" Economist's View. September 2, 2010.
Some critics see the policy as counterproductive and that large banks or other institutions should be left to fail if their risk management is not effective.Alton E. Drew, The Business Week, http://www.businessweek.com/bwdaily/dnflash/content/feb2009/db20090218_166676.htm retrieved on March 20, 2009 Moreover, some assert that the "too big to fail" policy has been explicitly refuted in the People's Republic of China
People's Republic of China
China , officially the People's Republic of China , is the most populous country in the world, with over 1.3 billion citizens. Located in East Asia, the country covers approximately 9.6 million square kilometres...
, with the insolvency of Guangdong International Trust & Investment Corporation in 1998.
Some economists, such as Nobel Laureate Paul Krugman
Paul Krugman
Paul Robin Krugman is an American economist, professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times...
, hold that economy of scale in banks, as in other
businesses, as worth preserving, so long as they are well regulated in proportion to their economic clout, and therefore that "too big to fail" status can be acceptable. The global economic system must also deal with sovereign states being too big to fail.Paul Krugman "Financial Reform 101" April 1, 2010Paul Krugman "Stop 'Stop Too Big To Fail'." April 21, 2010Paul Krugman "Too big to fail FAIL" June 18, 2009Paul Krugman "A bit more on too big to fail and related" June 19, 2009 Others, such as Alan Greenspan
Alan Greenspan
Alan Greenspan is an American economist who served as Chairman of the Federal Reserve of the United States from 1987 to 2006. He currently works as a private advisor and provides consulting for firms through his company, Greenspan Associates LLC...
, disagree: “If they’re too big to fail, they’re too big”.
Regulatory basis
Before 1950, U.S. federal bank regulators had essentially two options for resolving an insolvent institution: closure, with liquidation of assets and payouts for insured depositors, or purchase and assumption, encouraging the acquisition of assets and assumption of liabilities by another firm. A third option was made available by the Federal Deposit Insurance Act of 1950: providing assistance, the power to support an institution through loans or direct federal acquisition of assets, until it could recover from its distress. The statute limited the "assistance" option to cases where "continued operation of the bank is essential to provide adequate banking service." Regulators shunned this third option for many years, fearing that if regionally or nationally important banks were thought to be generally immune to liquidation, markets in their shares would be distorted. Thus, the assistance option was never employed during the period 1950-1969, and very seldom thereafter.http://marriottschool.byu.edu/emp/HBH/mba624/Commercial%20Banking%20Regulation.pdf Heaton, Hal B., Riegger, Christopher. "Commercial Banking Regulation", Class discussion notes.Distress
The Continental Illinois National Bank and Trust CompanyContinental Illinois National Bank and Trust Company
The Continental Illinois National Bank and Trust Company was at one time the seventh-largest bank in the United States as measured by deposits with approximately $40 billion in assets. In 1984, Continental Illinois became the largest ever bank failure in U.S. history, when a run on the bank led to...
experienced a fall in its overall asset quality during the early 1980s. Tight money, Mexico's default and plunging oil prices followed a period when the bank had aggressively pursued commercial lending business, Latin American syndicated loan
Syndicated loan
A syndicated loan is one that is provided by a group of lenders and is structured, arranged, and administered by one or several commercial banks or investment banks known as arrangers....
business, and loan participations in the energy sector. Complicating matters further, the bank's funding mix was heavily dependent on large CDs
Certificate of deposit
A certificate of Deposit is a time deposit, a financial product commonly offered to consumers in the United States by banks, thrift institutions, and credit unions....
and foreign money market
Money market
The money market is a component of the financial markets for assets involved in short-term borrowing and lending with original maturities of one year or shorter time frames. Trading in the money markets involves Treasury bills, commercial paper, bankers' acceptances, certificates of deposit,...
s, which meant its depositors were more risk-averse than average retail depositors in the US.
Payments crisis
The bank held significant participation in highly-speculative oil and gas loans of Oklahoma's Penn Square BankPenn Square Bank
Penn Square Bank was a small commercial bank located in the rear of the Penn Square Mall in Oklahoma City. The bank made its name in high-risk energy loans during the late 1970s and early 1980s Oklahoma and Texas oil boom. Between 1974 and 1982, the bank's assets increased more than 15 times to...
Belly Up, Phillip Zweig, Ballantine Books, 1986. When Penn Square failed in July 1982, the Continental's distress became acute, culminating with press rumors of failure and an investor-and-depositor run
Bank run
A bank run occurs when a large number of bank customers withdraw their deposits because they believe the bank is, or might become, insolvent...
in early May 1984. In the first week of the run, the Fed
Federal Reserve System
The Federal Reserve System is the central banking system of the United States. It was created on December 23, 1913 with the enactment of the Federal Reserve Act, largely in response to a series of financial panics, particularly a severe panic in 1907...
permitted the Continental Illinois discount window
Discount window
The discount window is an instrument of monetary policy that allows eligible institutions to borrow money from the central bank, usually on a short-term basis, to meet temporary shortages of liquidity caused by internal or external disruptions...
credits on the order of $3.6 billion. Still in significant distress, the management obtained a further $4.5 billion in credits from a syndicate of money center banks the following week. These measures failed to stop the run, and regulators were confronted with a crisis.
Regulatory crisis
The seventh-largest bank in the nation by deposits would very shortly be unable to meet its obligations. Regulators faced a tough decision about how to resolve the matter. Of the three options available, only two were seriously considered. Even banks much smaller than the Continental were deemed unsuitable for resolution by liquidation, owing to the disruptions this would have inevitably caused. The normal course would be to seek a purchaser (and indeed press accounts that such a search was underway contributed to Continental depositors' fears in 1984). However, in the tight-money financial climateEarly 1980s recession
The early 1980s recession describes the severe global economic recession affecting much of the developed world in the late 1970s and early 1980s. The United States and Japan exited recession relatively early, but high unemployment would continue to affect other OECD nations through at least 1985...
of the early 1980s, no purchaser was forthcoming.
Besides generic concerns of size, contagion of depositor panic and bank distress, regulators feared the significant disruption of national payment and settlement systems. Of special concern was the wide network of correspondent banks with high percentages of their capital invested in the Continental Illinois. Essentially, the bank was deemed "too big to fail," and the "provide assistance" option was reluctantly taken. The dilemma now became, how to provide assistance without significantly unbalancing the nation's banking system?
Stopping the run
To prevent immediate failureInsolvency
Insolvency means the inability to pay one's debts as they fall due. Usually used to refer to a business, insolvency refers to the inability of a company to pay off its debts.Business insolvency is defined in two different ways:...
, the Federal Reserve announced categorically that it would meet any liquidity needs the Continental might have, while the Federal Deposit Insurance Corporation
Federal Deposit Insurance Corporation
The Federal Deposit Insurance Corporation is a United States government corporation created by the Glass–Steagall Act of 1933. It provides deposit insurance, which guarantees the safety of deposits in member banks, currently up to $250,000 per depositor per bank. , the FDIC insures deposits at...
(FDIC) gave depositors and general creditors a full guarantee (not subject to the $100,000 FDIC deposit-insurance limit) and provided direct assistance of $2 billion (including participations). Money center banks assembled an additional $5.3 billion unsecured facility pending a resolution and resumption of more-normal business. These measures slowed, but did not stop, the outflow of deposits.
Controversy
In a United States SenateUnited States Senate
The United States Senate is the upper house of the bicameral legislature of the United States, and together with the United States House of Representatives comprises the United States Congress. The composition and powers of the Senate are established in Article One of the U.S. Constitution. Each...
hearing afterwards, the then Comptroller of the Currency C. T. Conover
C. T. Conover
Todd C. Conover was Comptroller of the Currency in the United States from 1981 to 1985 Conover, a California banking and management consultant, was named Comptroller by President Ronald Reagan...
defended his position by admitting the regulators will not let the largest 11 banks fail. Regulatory agencies (FDIC, Office of the Comptroller of the Currency
Office of the Comptroller of the Currency
The Office of the Comptroller of the Currency is a US federal agency established by the National Currency Act of 1863 and serves to charter, regulate, and supervise all national banks and the federal branches and agencies of foreign banks in the United States...
, the Federal Reserve System
Federal Reserve System
The Federal Reserve System is the central banking system of the United States. It was created on December 23, 1913 with the enactment of the Federal Reserve Act, largely in response to a series of financial panics, particularly a severe panic in 1907...
, etc.) feared this may cause widespread financial complications and a major bank run
Bank run
A bank run occurs when a large number of bank customers withdraw their deposits because they believe the bank is, or might become, insolvent...
that may easily spread by financial contagion. The implicit guarantee of too-big-to-fail has been criticized by many since then for its preferential treatment of large banks. Simultaneously, the perception of too-big-to-fail may diminish healthy market discipline
Market discipline
Buyers and sellers in a market are said to be constrained by market discipline in setting prices because they have strong incentives to generate revenues and avoid bankruptcy...
, and may have influenced the decisions behind the insolvency of Washington Mutual
Washington Mutual
Washington Mutual, Inc. , abbreviated to WaMu, was a savings bank holding company and the former owner of Washington Mutual Bank, which was the United States' largest savings and loan association until its collapse in 2008....
in 2008. For example, large depositors in banks not covered by the policy tend to have a strong incentive to monitor the bank's financial condition, and/or withdraw in case the bank's policies exposes them to high risks, since FDIC guarantees have an upper limit. However, large depositors in a "too big to fail" bank would have less incentive, since they'd expect to be bailed out in the event of failure.
The Federal Deposit Insurance Corporation Improvement Act
Federal Deposit Insurance Corporation Improvement Act of 1991
The Federal Deposit Insurance Corporation Improvement Act of 1991 , passed during the Savings and loan crisis, strengthened the power of the Federal Deposit Insurance Corporation....
was passed in 1991, giving the FDIC the responsibility to rescue an insolvent bank by the least costly method. The Act had the implicit goal of eliminating the widespread belief among depositors that a loss of depositors and bondholders will be prevented for large banks. However, the Act included an exception in cases of systemic risk, subject to the approval of two-thirds of the FDIC Board of Directors, the Federal Reserve Board of Governors, and the Treasury Secretary.
Ron Suskind
Ron Suskind
Ron Suskind is a Pulitzer Prize winning American journalist and best-selling author. He was the senior national affairs writer for The Wall Street Journal from 1993 to 2000 and has published the books A Hope in the Unseen, The Price of Loyalty, The One Percent Doctrine, The Way of the World and...
claimed in his book Confidence Men
Confidence Men
Confidence Men: Wall Street, Washington and the Education of a President is a book by Ron Suskind, published by HarperCollins on September 20, 2011....
that the administration of Barack Obama considered breaking up Citibank and other large banks that had been involved in the financial crisis of 2008. Suskind claims that Obama's staff, such as Timothy Geithner, refused to do so. The administration and Geithner have denied this version of events. Book Details Dissension in Obama Economic Team, by MARK LANDLER, New York Times, September 15, 2011Geithner denies ignoring Obama's request on banks Associated Press, via CBSnews.com, September 19, 2011 2:31 PM
Effect on banks' cost of capital
Since the full amount of the deposits and debts of "too big to fail" banks are effectively guaranteed by the government, large depositors view deposits with these banks as a safer investment than deposits with smaller banks. Therefore, large banks are able to pay lower interest rates to depositors than small banks are obliged to pay. In October 2009, Sheila Bair, the current Chairperson of the FDIC, commented that "'Too big to fail' has become worse. It's become explicit when it was implicit before. It creates competitive disparities between large and small institutions, because everybody knows small institutions can fail. So it's more expensive for them to raise capital and secure funding.". A study conducted by the Center for Economic and Policy ResearchCenter for Economic and Policy Research
The Center for Economic and Policy Research is a progressive economic policy think-tank based in Washington, DC, founded in 1999. CEPR works on Social Security, the US housing bubble, developing country economies , and gaps in the social policy fabric of the US economy.According to its own...
found that the difference between the cost of funds
Cost of Funds Index
A cost of funds index or COFI is a regional average of interest expenses incurred by financial institutions, which in turn is used as a base for calculating variable rate loans. The interest rate on an adjustable rate mortgage, for example, is often linked to a regional COFI specified in the...
for banks with more than $100 billion in assets and the cost of funds for smaller banks widened dramatically after the formalization of the "too big to fail" policy in the U.S. in the fourth quarter of 2008. This shift in the large banks' cost of funds was in effect equivalent to an indirect "too big to fail" subsidy of $34.1 billion per year to the 18 U.S. banks with more than $100 billion in assets.
"Too big to fail is too big"
Mervyn KingMervyn King (economist)
An ex-officio member of the Bank's interest-rate setting Monetary Policy Committee since its inception in 1997, Sir Mervyn is the only person to have taken part in every one of its monthly meetings to date. His voting style is often seen as "hawkish", a perspective that emphasises the dangers of...
, the governor of the Bank of England
Bank of England
The Bank of England is the central bank of the United Kingdom and the model on which most modern central banks have been based. Established in 1694, it is the second oldest central bank in the world...
, called for banks that are "too big to fail" to be cut down to size, as a solution to the problem of banks having taxpayer-funded guarantees for their speculative investment banking activities. "If some banks are thought to be too big to fail, then, in the words of a distinguished American economist, they are too big. It is not sensible to allow large banks to combine high street retail banking with risky investment banking or funding strategies, and then provide an implicit state guarantee against failure." However, Alistair Darling
Alistair Darling
Alistair Maclean Darling is a Scottish Labour Party politician who has been a Member of Parliament since 1987, currently for Edinburgh South West. He served as the Chancellor of the Exchequer from 2007 to 2010...
disagreed; "Many people talk about how to deal with the big banks – banks so important to the financial system that they cannot be allowed to fail. But the solution is not as simple, as some have suggested, as restricting the size of the banks".
As well, Alan Greenspan
Alan Greenspan
Alan Greenspan is an American economist who served as Chairman of the Federal Reserve of the United States from 1987 to 2006. He currently works as a private advisor and provides consulting for firms through his company, Greenspan Associates LLC...
said that “If they’re too big to fail, they’re too big,” suggesting U.S. regulators to consider breaking up large financial institutions considered “too big to fail.” He added, “I don’t think merely raising the fees or capital on large institutions or taxing them is enough ... they’ll absorb that, they’ll work with that, and it’s totally inefficient and they’ll still be using the savings.”
Too big to fail tax
Willem BuiterWillem Buiter
Willem Hendrik Buiter Willem Hendrik Buiter Willem Hendrik Buiter (born September 26, 1949]] was a member of the Bank of England's Monetary Policy Committee from June 1997-May 2000. He joined the London School of Economics as a chair in the European Institute in September 2005....
proposes a tax to internalize the massive external costs inflicted by "too big to fail" institution. "When size creates externalities, do what you would do with any negative externality: tax it. The other way to limit size is to tax size. This can be done through capital requirements that are progressive in the size of the business (as measured by value added, the size of the balance sheet or some other metric). Such measures for preventing the New Darwinism of the survival of the fittest and the politically best connected should be distinguished from regulatory interventions based on the narrow leverage ratio aimed at regulating risk (regardless of size, except for a de minimis lower limit)."
Financial Stability Board list
On November 4, 2011, the Financial Stability BoardFinancial Stability Board
The Financial Stability Board is an international body that monitors and makes recommendations about the global financial system. It was established after the 2009 G-20 London summit in April 2009 as a successor to the Financial Stability Forum. The Board includes all G-20 major economies, FSF...
released a list of
29 banks worldwide that they considered to be "too big to fail". Of the
list, 17 banks are based in Europe, 8 in the U.S., and the other four in Asia:
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Dexia Dexia N.V./S.A., also referred to as the Dexia Group, is a Belgian-French financial institution active in public finance, providing retail and commercial banking services to individuals and SMEs, asset management, and insurance... Goldman Sachs The Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients... Crédit Agricole Crédit Agricole S.A. is the largest retail banking group in France, second largest in Europe and the eighth largest in the world by Tier 1 capital according to The Banker magazine. It is also part of the CAC 40 stock market index.... HSBC HSBC Holdings plc is a global banking and financial services company headquartered in Canary Wharf, London, United Kingdom. it is the world's second-largest banking and financial services group and second-largest public company according to a composite measure by Forbes magazine... Lloyds Banking Group Lloyds Banking Group plc is a major British financial institution, formed through the acquisition of HBOS by Lloyds TSB in 2009. As at February 2010, HM Treasury held a 41% shareholding through UK Financial Investments Limited . The Group headquarters is located at 25 Gresham Street in London, with... Mizuho Financial Group , abbreviated as MHFG, or simply called Mizuho is a banking holding company headquartered in the Ōtemachi district of Chiyoda, Tokyo, Japan... Morgan Stanley Morgan Stanley is a global financial services firm headquartered in New York City serving a diversified group of corporations, governments, financial institutions, and individuals. Morgan Stanley also operates in 36 countries around the world, with over 600 offices and a workforce of over 60,000.... |
Nordea Nordea Bank AB is a Stockholm-based financial services group operating in Northern Europe. The bank is the result of the successive mergers and acquisitions of the Swedish, Finnish, Danish and Norwegian banks of Nordbanken, Merita Bank, Unibank and Kreditkassen that took place between 1997 and 2000... Royal Bank of Scotland The Royal Bank of Scotland Group is a British banking and insurance holding company in which the UK Government holds an 84% stake. This stake is held and managed through UK Financial Investments Limited, whose voting rights are limited to 75% in order for the bank to retain its listing on the... Société Générale Société Générale S.A. is a large European Bank and a major Financial Services company that has a substantial global presence. Its registered office is on Boulevard Haussmann in the 9th arrondissement of Paris, while its head office is in the Tours Société Générale in the business district of La... Wells Fargo Wells Fargo & Company is an American multinational diversified financial services company with operations around the world. Wells Fargo is the fourth largest bank in the U.S. by assets and the largest bank by market capitalization. Wells Fargo is the second largest bank in deposits, home... |
See also
- Greenspan putGreenspan putThe "Greenspan Put" refers to the monetary policy approach that Alan Greenspan, the former Chairman of the United States Federal Reserve Board, and other Fed members exercised from the late 1987 to 2000....
- Lender of last resortLender of last resortA lender of last resort is an institution willing to extend credit when no one else will. The term refers especially to a reserve financial institution, most often the central bank of a country, intended to avoid bankruptcy of banks or other institutions deemed systemically important or 'too big to...
- List of largest U.S. bank failures
- 2008-2009 bank failures in the United States
- List of acquired or bankrupt United States banks in the late 2000s financial crisis
- Volcker RuleVolcker RuleThe Volcker Rule is a specific section of the Dodd–Frank Wall Street Reform and Consumer Protection Act originally proposed by American economist and former United States Federal Reserve Chairman Paul Volcker to restrict United States banks from making certain kinds of speculative investments that...