Too big to fail

Based on Wikipedia: Too big to fail

The Paradox of the Indispensable Bank

In September 2008, the United States government made a choice that still reverberates through the global economy. Lehman Brothers, a 158-year-old investment bank with over $600 billion in assets, was allowed to collapse. Within days, the financial system nearly ground to a halt. Credit markets froze. Stock markets plummeted worldwide. The economy tipped into what would become the worst recession since the Great Depression.

Just months earlier, the government had orchestrated a rescue of Bear Stearns. Just days later, it would pour billions into saving the insurance giant American International Group, commonly known as AIG. Why let Lehman fail but save the others?

The answer, such as it was, came down to a theory that had been quietly shaping government policy for decades: some institutions are simply too big to fail.

What "Too Big to Fail" Actually Means

The phrase sounds straightforward, but it carries a precise and troubling meaning. A "too big to fail" institution isn't just large. It's so deeply woven into the fabric of the economy that its sudden collapse would tear that fabric apart.

Federal Reserve Chair Ben Bernanke defined it this way in 2010: a too-big-to-fail firm is one whose size, complexity, interconnectedness, and critical functions mean that if it went into sudden liquidation, the rest of the financial system and the broader economy would face severe consequences. The government doesn't rescue these firms out of favoritism toward their executives or shareholders. It does so because letting them fail disorderly would inflict more damage than the cost of preventing the failure.

Notice the careful phrasing: "disorderly failure." An orderly wind-down, where creditors are paid off systematically and operations are transferred smoothly, might be survivable. But when a massive financial institution collapses suddenly, like a building whose supports give way all at once, the debris flies everywhere.

The Birth of an Idea

The term was popularized in 1984 by U.S. Congressman Stewart McKinney during a hearing about Continental Illinois, then the seventh-largest bank in America. Continental had made a disastrous bet on energy loans and was hemorrhaging deposits. The Federal Deposit Insurance Corporation, or FDIC, stepped in with a massive rescue package, and McKinney remarked that the government's actions proved some banks were simply "too big to fail."

But the underlying concept is much older. The basic logic can be traced back at least to the Panic of 1907, when the failure of the Knickerbocker Trust Company in New York triggered a nationwide financial crisis. That panic was eventually stemmed by J.P. Morgan, the financier, who personally organized a private bailout of key institutions. The crisis led Congress to create the Federal Reserve in 1913, giving the government its own tool for stabilizing the banking system.

The pattern repeated through the twentieth century. Banks failed. Crises spread. The government expanded its toolkit for rescues.

The Great Depression and the Insurance Solution

Before the Great Depression, American bank deposits came with no guarantee. If you put your money in a bank, you were essentially an unsecured creditor. If the bank made bad loans and collapsed, your savings disappeared.

This created a particular vulnerability: the bank run. When depositors heard rumors that their bank might be in trouble, they rushed to withdraw their money. But banks don't keep all depositor funds in a vault. They lend most of it out, keeping only a fraction on hand. This is called fractional reserve banking, and it works fine under normal circumstances. But when everyone demands their money at once, even a healthy bank can become insolvent.

During the Great Depression, bank runs became an epidemic. Hundreds of banks failed, wiping out the savings of millions of families. In response, Congress passed the Banking Act of 1933, which created the FDIC to insure deposits. Initially the coverage was $2,500 per depositor. Today it's $250,000.

This insurance changed the game. Depositors no longer had to panic when they heard bad news about their bank. Their money was safe regardless. In exchange for this government backstop, banks accepted heavy regulation of how they could invest depositor funds.

But the insurance also created something else: the first explicit too-big-to-fail policy for a specific sector of the financial system.

The Shadow Banking System

The Banking Act of 1933, sometimes called the Glass-Steagall Act, did more than create deposit insurance. It erected a wall between two different kinds of banking.

On one side were depository banks, the familiar institutions where ordinary people keep their savings accounts. These banks were required to invest conservatively. They couldn't gamble with depositor money.

On the other side were investment banks, which served wealthy individuals and corporations. These banks raised money from sophisticated investors who were presumed to understand the risks. Investment banks could make aggressive bets, speculate on their own behalf, and trade complex financial instruments.

For decades, this division held. Then, starting in the 1980s and accelerating in the 1990s, the walls began to crumble. Investment banks developed new products that looked like banking without technically being banking. Money market funds offered check-writing privileges and near-bank-like safety, but without FDIC insurance. Securitization allowed banks to package mortgages and other loans into bonds that could be sold to investors.

By 2007, this "shadow banking system" had grown to rival the traditional banking system in size. It provided similar functions: gathering savings, making loans, enabling payments. But it operated without deposit insurance and without the same regulatory oversight.

When the housing market turned and mortgage-backed securities plummeted in value, the shadow banking system experienced something equivalent to a classic bank run. But instead of depositors lining up outside branch offices, it was investors demanding their money back from money market funds and refusing to roll over short-term loans to investment banks.

In 2008 alone, all five of the largest independent U.S. investment banks either failed, were acquired at fire-sale prices, or converted themselves into traditional bank holding companies to gain access to Federal Reserve support. Lehman Brothers went bankrupt. Bear Stearns was sold to JP Morgan Chase for a fraction of its previous value. Merrill Lynch was absorbed by Bank of America. Goldman Sachs and Morgan Stanley obtained depository banking charters.

The shadow banking system, it turned out, had its own too-big-to-fail institutions. Nobody had just been paying attention.

The Moral Hazard Problem

Here is the fundamental paradox of too-big-to-fail policy: the more credibly the government promises to rescue large institutions, the more recklessly those institutions will behave.

Economists call this "moral hazard," a term borrowed from the insurance industry. If you know your fire insurance will cover any losses, you might be less careful about checking that the stove is off.

For banks, the moral hazard works like this: if creditors believe a large bank will never be allowed to fail, they won't demand as much compensation for lending to that bank. They won't charge higher interest rates to account for risk. They won't scrutinize the bank's investments as carefully. Why bother? The government will step in if anything goes wrong.

From the bank's perspective, this creates a wonderful opportunity. It can take bigger risks than would otherwise make sense, because the downside is limited. If the risky bets pay off, the bank keeps the profits. If they don't, the government absorbs the losses.

This isn't hypothetical. Research has shown that banks approaching certain size thresholds are willing to pay a premium for acquisitions that push them over those lines, precisely because being designated too-big-to-fail brings tangible financial advantages.

The Subsidy Hidden in Plain Sight

How much is it worth to be too big to fail? Researchers have tried to quantify this hidden subsidy, and the numbers are staggering.

One study by the Center for Economic and Policy Research found that after the government's response to the 2008 crisis made the too-big-to-fail policy explicit, the largest banks gained a funding advantage equivalent to about $34 billion per year. They could borrow money more cheaply than smaller banks simply because lenders knew the government stood behind them.

Bloomberg View estimated the figure even higher: an $83 billion annual subsidy to the ten largest U.S. banks, reflecting a funding advantage of roughly 0.8 percentage points. To put that in perspective, the combined profits of these banks were roughly in the same range. Their apparent profitability, in other words, was largely an artifact of taxpayer support.

Another study tracked the subsidy through the crisis years of 2007 to 2010 and found that America's biggest banks saved roughly $120 billion from their perceived safety net. Citigroup alone saved an estimated $53 billion. Bank of America saved $32 billion. JPMorgan saved $10 billion.

This creates an unfair competitive environment. Large banks can offer lower interest rates to depositors, attract more business, grow even larger, and reinforce their too-big-to-fail status. Small banks, competing without the implicit government backstop, face higher funding costs and struggle to keep up.

As Sheila Bair, then chairwoman of the FDIC, observed in 2009: "Too big to fail has become worse. It's become explicit when it was implicit before. It creates competitive disparities between large and small institutions, because everybody knows small institutions can fail."

The Concentration Continues

You might expect that after the 2008 crisis revealed the dangers of massive financial institutions, policymakers would work to make banks smaller. The opposite happened.

During the crisis itself, the government encouraged mergers that made the big banks even bigger. JP Morgan Chase absorbed Bear Stearns and Washington Mutual. Bank of America absorbed Merrill Lynch and Countrywide. Wells Fargo absorbed Wachovia.

The numbers tell the story. In 1998, the five largest U.S. banks held approximately 30 percent of all U.S. banking assets. By 2008, that figure had risen to 45 percent. By 2010, it reached 48 percent.

The number of banking institutions has steadily fallen. In 1984, the United States had 14,495 commercial and savings banks. By 2010, that number had dropped to 6,532. The industry was consolidating, and the giants were getting bigger.

The Debate Over Solutions

What should be done about too-big-to-fail institutions? The debate breaks down into several camps.

One group argues for breaking up the largest banks. Alan Greenspan, the former Federal Reserve chairman once celebrated as a champion of deregulation, came to endorse this view. "If they're too big to fail," he said, "they're too big." Proponents of this approach point out that before the wave of mergers and consolidation, the banking system worked fine with smaller institutions. Breaking up the giants would eliminate the systemic risk they pose.

A second group argues that size isn't really the problem. Economist Paul Krugman has pointed out that during the Great Depression, the banking system collapsed despite being composed entirely of small banks. The real issue, in this view, is inadequate regulation. If banks are properly supervised and required to hold sufficient capital against their risks, their size matters less.

A third approach focuses on creating better procedures for winding down large institutions when they fail. If the government had the tools to let Lehman Brothers fail in an orderly way, the argument goes, the cascade of damage might have been contained. The Dodd-Frank Act, passed in 2010 in response to the crisis, attempted to create such "resolution authority."

The evidence on whether Dodd-Frank succeeded is discouraging. Studies conducted after its passage found that the implicit subsidy enjoyed by too-big-to-fail banks remained intact. Credit rating agencies continued to assume the largest banks would receive government support in a crisis. In 2014, the International Monetary Fund concluded the problem still hadn't been solved.

The Fundamental Tension

At the heart of the too-big-to-fail problem lies a tension that may be irresolvable.

On one side is the reality that modern financial systems require large, interconnected institutions. Banks provide liquidity to markets. They enable transactions across borders. They intermediate between savers who want safety and borrowers who need capital. A banking system composed entirely of small, isolated institutions might be more stable, but it would also be less efficient at performing these essential functions.

On the other side is the reality that government cannot credibly commit to letting large institutions fail. When the collapse of a single company threatens to bring down the entire economy, every incentive pushes toward rescue. The politicians who would have to take the blame for an economic catastrophe, the regulators who would be accused of negligence, the ordinary citizens who would lose their jobs and savings: all of them have powerful reasons to support a bailout when the alternative is chaos.

This was the lesson of Lehman Brothers. The government decided to let it fail, partly to demonstrate that too-big-to-fail had limits. The resulting damage was so severe that the government immediately pivoted to rescuing everyone else.

Critics like Senator Bernie Sanders have argued that if taxpayers are on the hook when big banks fail, taxpayers should share in the profits when those banks succeed. Others have suggested that banks benefiting from implicit government guarantees should pay for that privilege through higher taxes or fees. But these proposals run into political opposition from the banking industry itself, which has considerable influence over the legislative process.

A Permanent Feature of Modern Finance?

The honest assessment may be that too-big-to-fail is a permanent feature of modern financial systems, not a problem that can be definitively solved.

Large financial institutions have existed for centuries, and governments have been rescuing them for nearly as long. The Panic of 1907 was resolved through a private bailout organized by J.P. Morgan, but the government's subsequent creation of the Federal Reserve was an acknowledgment that such crises required public solutions. The Great Depression led to deposit insurance. The savings and loan crisis of the 1980s led to massive government intervention. The 2008 crisis led to trillions of dollars in bailouts and emergency lending.

Each crisis prompts reforms designed to prevent the next one. And each set of reforms eventually proves inadequate when conditions change and new risks emerge.

This cycle may simply be the price of having a sophisticated financial system. Large institutions emerge because they're efficient at providing financial services. Their interconnection creates systemic risk. Governments can't credibly promise to let them fail. Knowing this, the institutions take more risks than they otherwise would. Eventually, some of those risks materialize.

What we can do is try to make the cycle less severe. Better regulation can reduce the frequency of crises. Higher capital requirements can ensure that banks have cushions to absorb losses. Improved resolution procedures can make failures more orderly. But the fundamental tension between the efficiency of large institutions and the risk they pose to the system seems likely to endure.

The Philosophical Question

Behind all the technical details lies a question about how we organize our economy and who bears its risks.

When a small business fails, its owners lose their investment. When a worker is laid off, they lose their income. These failures are painful but contained. The broader economy absorbs them and moves on.

But when a too-big-to-fail institution threatens to collapse, the logic inverts. The institution's creditors and executives may be shielded from the consequences of their decisions because those consequences would be too severe for everyone else. Risk that was supposed to be private becomes public. Losses that were supposed to fall on those who made bad decisions instead fall on taxpayers who had no say in those decisions.

This is, as Alan Greenspan acknowledged, antithetical to how market systems are supposed to work. "Failure is an integral part, a necessary part of a market system," he said. When firms that make bad decisions are rescued instead of punished, the market's discipline breaks down.

Yet the alternative, letting massive institutions fail and accepting the resulting economic devastation, is also unacceptable. We saw a preview of that alternative in September 2008, and we recoiled.

So we muddle through, neither fully accepting too-big-to-fail nor fully rejecting it, hoping each crisis will be the last while knowing it probably won't be. The banks get bigger. The risks accumulate. And somewhere, in some corner of the financial system we haven't thought to regulate, the seeds of the next crisis are quietly being planted.