Question

the federal reserve system has suggested that some very large banks in the US are too big to fail. If the feds adopt such a policy stance, what problem will it probably face as it seeks to cope with troubled banks?

Answer 1

"Too big to fail" describes a concept in which the government will intervene in situations where a business has become so deeply ingrained in the functionality of an economy that its failure would be disastrous to the economy at large. If such a company fails, it would likely have a catastrophic ripple effect throughout the economy.

The failure can trigger issues with businesses that depend on the company as a client of the failed company as well as issues with unemployment as employees lose their employment. In these situations, the government will conceptually consider the cost of a bailout compared to the cost of allowing economic failure in a decision to allocate aid funds.

It's hardly a fresh problem. In one event, an extension of the classic problem of bank runs and panics was too big to fail. If a big bank failed— whether it was illiquid after a deposit run or insolvent after serious loss— the entire banking system could be put at risk. In cases where other banks held large deposits in the troubled institution, a large bank's failure could lead directly to other banks ' illiquidity or insolvency. The result could be a domino effect in the interbank lending market, with one bank's failure toppling the next. Even where direct losses to other banks were thought manageable, the failure of a large bank might strike panic into depositors, especially uninsured depositors, of other large institutions. The result might be a far-reaching run on the entire banking system that could, in a worst case such as occurred in early 1933, freeze the financial system completely.

One issue stems from the impacts on bank creditors ' incentives and the banks themselves, potentially. Creditors who think that the government will consider an organization too large to fail may not price the institution's complete danger in their loan extensions. That's the very definition of moral hazard, of course. The organization therefore has resources at its disposal at a cost that does not internalize completely the social expenses connected with its activities.  The consequences are a diminution of market discipline, inefficient allocation of capital, the socialization of losses from supposedly market-based activities, and a competitive advantage for the large institution compared to smaller banks.