Question

What does it mean to say a bank is ‘too big to fail’? What ‘moral hazard’ results from a bank being ‘too big to fail’?   

Answer 1

Too big to fail means if failed it will lead to a catastrophe. The regulatory body or the central bank considers some banks as too big to fail. They have a huge amount of deposits and carry out financial transactions on a massive amount that a country's economy is affected if the bank goes down.

Loss of employment, companies that depend on the banks etc are at stake. It is kind of a serial collapse where one failure will lead to next failure and the chain goes on.

Therefore, if the cost of a bailout is less than the cost of the failure to the economy, a government may decide a bailout which is the most cost-effective solution.

This concept was integral to the financial crisis of the late 2000s when the U.S. government disbursed $700 billion to save companies, such as AIG, which were on the verge of financial failure.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 was created to avoid future bailouts. The Act requires creating living wills outlining how they will liquidate assets quickly if filing for bankruptcy. In November 2015, an international board of financial regulators published rules requiring big banks to raise up to $1.2 trillion in new debt funding that can be written off or converted to equity in case of losses.