Question

During the 2008-9 financial crisis what was meant by regulators and bankers when they used the phrase or referred to the concept of “too big to fail”? Please provide a brief description of the concept and the implications of the concept during the 2008-9 crisis (short answer)?

Answer 1

Too big to fail (TBTF) is a doctrine postulating that the government cannot allow very big firms (particularly major banks and financial institutions) to fail, for the very reason that they are big.

Bush's administration popularized "too big to fail" during the 2008 financial crisis. The administration used the phrase to describe why it had to bail out some financial companies to avoid worldwide economic collapse. ... These banks were so heavily invested in these derivatives that they became too big to fail.

The following are the important points:

• "Too big to fail" describes a business or sector whose collapse would cause catastrophic damage to the economy.
• The government will often intervene in situations where failure poses a grave risk to the economy.
• One example of such intervention was the Emergency Economic Stabilization Act of 2008, which included the $700 billion Troubled Asset Relief Program (TARP).

Implications :

Governments cannot credibly commit to eschew bailouts of creditors when large financial institutions become distressed.

This too-big-to-fail (TBTF) problem distorts how markets price securities issued by TBTF firms, thus encouraging them to borrow too much and take too much risk. TBTF also encourages financial firms to grow, leading to competitive inequity and potential misallocation of credit.

This review discusses evidence that such distortions are empirically relevant and also discusses the policy efforts to limit them. In the wake of the Financial Crisis of 2007–2008, it seems increased concentration in the financial industry has worsened the TBTF problem. Nevertheless, markets price the risks of large financial firms more now than before the Financial Crisis.