Question

Too Big to Fail", has become a phrase associated with the banking industry and even gave rise to a film on the financial crisis of 2007-2009. Here are some questions you may discuss and comment on (See the links under Resources below for additional information):

Do you think that with all the regulations in place now, including the Dodd-Frank Act of 2010, and the recent changes to the act, we can avoid another major financial bail-out?

Can you identify the REAL "TOO BIG TO FAIL" institution that caused the very big problem?

Were the banks' problems caused by derivatives? Interest rate risk? Other factors?

Answer 1

"Too big to fail" describes the concept whereby a business has become so large that a government will provide assistance to prevent its failure because not doing so would have a disastrous ripple effect throughout the economy. If a large company fails, companies that rely on it for portions of their income might also be extinguished along with the employment they provide. Therefore, if the cost of a bailout is less than the cost of the failure to the economy, a government may decide a bailout is the most cost-effective solution.

“Too big to fail” is the idea that specific businesses, such as the biggest banks, are so vital to the U.S. economy that it would be disastrous if they went bankrupt. To avoid a crisis, the government might provide bailouts to protect creditors against losses and enable managers to retain their high wages and bonuses. 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, that were on the verge of financial failure.

Because of bank failures during the Great Depression, deposit insurance and regulators, such as the Federal Deposit Insurance Corporation (FDIC), were created to take over and efficiently liquidate failing banks. In 2007 and 2008, deeply indebted investment banks without FDIC protection faced failure as creditors and shareholders doubted their solvency. When Lehman Brothers collapsed, regulators discovered the biggest firms were so interconnected that only large bailouts would prevent half the financial sector from failing.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 was created to avoid future bailouts. Part of the Act requires financial institutions to create 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.

Will Dodd-Frank prevent future bank bailouts?

Dodd-Frank does intend to make it easier for failing or distressed banks to sell off operations, raise capital and close down. It also gives the government new authority to help liquidate firms and avoid taxpayer bailouts, ensuring that firms’ shareholders and creditors bear the losses. Problem is, this “resolution authority” applies only in the United States. So, as MIT economist Simon Johnson explained during a congressional hearing on the issue this week, distressed global megabanks could still majorly threaten the U.S. financial system if they go down in a big, messy way. What’s more, there’s nothing explicitly prohibiting the government from making emergency rescues. And even when they do have the resolution authority over a bank, Johnson points out that it’s unclearwhether federal officials would be quick enough and courageous enough to liquidate a firm if they see problems on the horizon, but before a bankruptcy is imminent.

To address some of these weaknesses, Johnson advocates for imposing hard limits on the asset size of financial institutions, making them “small and simple enough so they can fail — i.e., go bankrupt — without adversely affecting the rest of the financial sector.” Together with James Kwak, he’s proposed a maximum size limit of 4 percent of GDP for commercial banks and 2 percent of GDP for securities firms, using the approximate size of the biggest financial players in the mid-1990s — before the current era of speculative, volatile trading — as a guide.

Johnson would also increase capital requirements, so at least domestically, U.S. firms would be better protected. Finally, the United States would urge leading European nations to do the same to shore up their financial system and provide a more equal playing field. (Though the Eurozone crisis makes this unlikely in the near future, it also highlights the need for better-capitalized banks.)

But an inflexible, concrete cap on bank size has little political chance of passing any time soon: Congress overwhelmingly voted down a similar proposal during the Dodd-Frank debate. “Who determines when a bank becomes ‘too big’? By what measure?” asks Phillip Klein of the Washington Examiner. And some supporters of Dodd-Frank argue that “there is nothing inherently wrong with size in and of itself,” as Sheila Bair, former FDIC chair, said at Wednesday’s hearing.

Art Wilmarth*, a law professor at George Washington University, alternatively suggests forcing banks to pay a kind of insurance risk premium to finance the future costs of resolving failed banks and firms that threatened the entire financial system. He would also make banks spin off some of their riskier activities — namely their derivatives trading and dealing activities — into non-bank affiliates, in line with a proposal that was ultimately watered down during the Dodd-Frank debate. He points out that the U.K.’s Cameron government has already pledged to impose stricter separation between “utility” and “casino” banking operations, arguing that the United States and Britain could set a new precedent by their leadership.

Wilmarth argues that these measures are necessary in the United States precisely because investors in these big financial firms still believe that the government will bail them out, if need be, fueling a sort of “moral hazard” that critics say distorts the market.

Real too big fails -

Many of the top banks are far too overexposed in the bets they have made. The top banks seem to be addicted to gambling and the bets they are making are increasingly risky. Derivatives have come under public scrutiny recently with JPMorgan's $2 billion trading loss on a derivatives trade. Jamie Dimon was forced to apologize and several people left over the trade. This trade has been called a colossal error, however, it was practically nothing of the true exposure banks like JPMorgan have to the derivative markets. It is a very dangerous game that these five banks are playing, and if everything goes wrong, they do not have the money to pay for the derivative bets they are making

These banks hedge their derivative bets against each other so supposedly they cannot lose. This creates the perception that what they are doing is safe. However, the recent trading loss for JPMorgan shows that this is in fact not the case. If there is a sudden change that they do not expect, then the banks do lose on derivative trades. Especially during these uncertain times, the management of these banks should realize that there is the potential for the market to be very surprising. Therefore, these derivative bets are very risky bets. Depending on the derivative bets, if the market tanks or improves rapidly, these banks might have too much exposure in derivatives to be saved. Imagine having to repay $1 trillion, the fact is it would simply not be possible. The worst thing is that the banks have taken too many liberties because they realize they are so big that the taxpayer will intervene to bail them out.

This recent terrible bet by JPMorgan has proved that even the 'best' banks are capable of gigantic blunders

Examples of Too Big to Fail Banks

Lehman Brothers was an investment bank. It wasn't a big company, but the impact of its bankruptcy was alarming. In 2008, Treasury Secretary Hank Paulson said no to its bailout, and it filed for bankruptcy. On the following Monday, the Dow dropped 350 points. By Wednesday, financial markets panicked. That threatened the overnight lending needed to keep businesses running.

The problem was beyond what monetary policy could do. That meant a $700 billion bailout was necessary to recapitalize the major banks.

Citigroup received a $20 billion cash infusion from Treasury. In return, the government received $27 billion of preferred shares yielding 8 percent annual return. It also received warrants to buy no more than 5% of Citi's common shares at $10 per share.

The investment banks Goldman Sachs and Morgan Stanley were also too big to fail. The Fed bailed them out by allowing them to become commercial banks. That meant they could borrow from the Fed's discount window. They could take advantage of the Fed's other guarantee programs intended for retail banks. That ended the era of investment banking made famous by the movie "Wall Street." The 1980s mantra, "Greed is good," was now seen in its true colors. Wall Street greed led to taxpayer and homeowner pain.