Economy

too big to fall

What is too big to fail?

“Too big to fail” refers to a business or business sector that is thought to be so ingrained in the financial system or economy that its failure would have catastrophic effects on the economy. As a result, the government will consider bailing out companies and even entire industries—such as Wall Street banks or U.S. automakers—to prevent economic catastrophe.

Financial institutions that are “too big to fail”

Perhaps the most vivid recent example of “too big to fail” is the bailout of Wall Street banks and other financial institutions during the global financial crisis. Following the collapse of Lehman Brothers, Congress passed the Emergency Economic Stabilization Act (EESA) in October 2008. These include the $700 billion Troubled Asset Relief Program (TARP), which authorizes the U.S. government to buy distressed assets to stabilize the financial system.

This ultimately means the government is bailing out big banks and insurance companies because they are “too big to fail,” meaning their failure could lead to the collapse of the financial system and the economy. They later faced additional provisions from the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

key takeaways

  • “Too big to fail” means that the failure of a business or sector would cause catastrophic damage to the economy.
  • The U.S. government could intervene if the failure poses a serious risk to the economy.
  • An example of such intervention is the Emergency Economic Stabilization Act of 2008, which included the $700 billion Troubled Asset Relief Program (TARP).

Bank Reform Background

After thousands of bank failures in the 1920s and early 1930s, the Federal Deposit Insurance Corporation (FDIC) was created to monitor banks and insure customers’ deposits, so Americans can trust that their money is safe in the bank. The FDIC now insures individual accounts at member banks up to $250,000 per depositor.

The early 2000s brought new challenges to banking regulation, with banks developing financial products and risk models unimaginable in the 1930s. The 2007-2008 financial crisis exposed risks.

“Too big to fail” became a common phrase during the 2007-2008 financial crisis, which led to reforms in the US and global financial sectors.

Dodd-Frank Act

The Dodd-Frank Act was passed in 2010 to help avoid any future bailouts of the financial system. Among its many regulations are new rules on capital requirements, proprietary trading and consumer lending. Dodd-Frank also imposed higher requirements on banks collectively known as systemically important financial institutions (SIFIs).

Global Banking Reform

The 2007-2008 financial crisis affected banks around the world. Global regulators have also implemented reforms, with most of the new regulations focused on too-big-to-fail banks. Global banking supervision is mainly carried out by the Basel Committee on Banking Supervision, the Bank for International Settlements and the Financial Stability Board.

Examples of global SIFIs include:

  • Mizuho
  • Bank of China
  • BNP Paribas
  • Deutsche Bank
  • Credit Suisse

Examples of “too big to fail” companies

The Federal Reserve said banks that could threaten the stability of the U.S. financial system include:

  • Bank of America
  • Bank of New York Mellon Corporation
  • Citigroup
  • Goldman Sachs Group of Companies
  • JPMorgan Chase & Co.
  • Morgan Stanley
  • State Street Corporation
  • FuGuo bank

Other entities deemed “too big to fail” and requiring government intervention are:

  • General Motors (Automotive Company)
  • AIG (Insurance Company)
  • Chrysler (automotive company)
  • Fannie Mae (Government Sponsored Enterprise (GSE))
  • Freddie Mac (GSE)
  • GMAC – now Ally Financial (financial services company)

Support the “too big to fail” theory

In supporting regulation, the Dodd-Frank Act, passed in July 2010, requires banks to limit their risk-taking by holding larger financial reserves and other measures. In the event of any difficulties for banks or the wider financial system, banks must maintain a higher proportion of high-quality, easy-to-sell assets. These are called capital requirements.

The Consumer Financial Protection Bureau (CFPB) is designed to prevent predatory mortgage lending practices and make it easier for consumers to understand mortgage terms before agreeing to them. Other features of the institution are built to deter bad actors from preying on potential borrowers.

Criticism of ‘too big to fail’

Criticisms of too-big-to-fail regulation include discussions that, despite the government’s massive capital and liquidity aid programs for banks and large non-bank financial institutions, there is significant political scrutiny over the use of government bailouts as a policy tool rebound.

One concern is that if any financial institution is so important that the government cannot allow it to fail, investors will lend it too cheaply. Such subsidies provide an advantage over smaller rivals and encourage borrowing beyond safety limits, making a collapse more likely. Customers recognize that their investments in big banks are safer than deposits in small banks. As a result, the big banks are able to pay their customers lower rates than the small banks have to pay to attract depositors.

In the rush to block any potential future government bailouts, new vulnerabilities could be created that could exacerbate the next disaster. Regulators are now forcing the biggest financial firms to have more capital to prevent losses. This makes them less likely to fail and less profitable, inhibiting growth to a “too big to fail” ratio.

Is “too big to fail” a new concept?

U.S. Rep. Stuart McKinney (R-Conn.) promulgated the term during a 1984 congressional hearing discussing the Federal Deposit Insurance Corporation’s (FDIC) intervention with the Continental Bank of Illinois. Although the term has been used before—for example, in 1975, it was used to describe the government bailout of Lockheed Corporation—Wall Street received a government bailout during the 2007-2008 global financial crisis , it became more widely known. Other government regulations were subsequently enacted to reduce the likelihood of these events, including the Emergency Economic Stabilization Act of 2008 and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

What protections can mitigate “too big to fail”?

Regulations have been enacted to require systemically important financial institutions to maintain adequate capital and subject to enhanced regulatory and resolution mechanisms.

Many economists, financial experts, and even the banks themselves have called for breaking up large banks into smaller institutions.

More government regulations were enacted after the collapse of major financial institutions in 2008 to reduce the likelihood of such events. These include the Emergency Economic Stabilization Act of 2008 and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

bottom line

To protect the U.S. economy from a catastrophic financial failure that could have global repercussions, the government could step in and bail out a systemically critical business—or even an entire sector of the economy, such as the transportation or auto industries—in the event of a financial crisis.

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