Content of the material
What Is Too Big to Fail?
“Too big to fail” describes a business or business sector deemed to be so deeply ingrained in a financial system or economy that its failure would be disastrous to the economy. Therefore, the government will consider bailing out the business or even an entire sector—such as Wall Street banks or U.S. carmakers—to prevent economic disaster.
4 Policy measures implemented after the crisis
Capital requirements and resolution regimes were at the core of the regulatory reforms that were implemented after the global financial crisis. This section describes what was actually decided and how policies are evaluated. We start with an overview of the institutions in charge.
Firms That Were Rescued
After receiving a $25 billion injection, Citigroup received $20 billion in cash from the Treasury. In return, the government received $27 billion of preferred shares yielding an 8% 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 bailed out by the Federal Reserve (the Fed), which allowed them to become bank holding companies, meaning that they would be regulated by the government.
The banks could then borrow from the Fed's discount window and take advantage of the Fed's other guarantee programs intended for retail banks. With the collapse of these investment banks, the era of ultra-successful investment banking was over.
AIG Insurance Company
The American International Group (AIG) was one of the world’s largest insurance companies. Most of its business consisted of traditional insurance products. When the company delved into credit default swaps, it began taking enormous risks.
These swaps insured the mortgage securities purchased by investors, in an attempt to reduce the risk of the securities if the borrowers defaulted. If AIG had gone bankrupt, it would have triggered the failure of the financial institutions that bought those swaps.
AIG’s swaps against subprime mortgages pushed it to the brink of bankruptcy. As the mortgages tied to the swaps defaulted, AIG was forced to raise millions in capital. As stockholders got wind of the situation, they sold their shares, making it even harder for AIG to cover the swaps.
Even though AIG had more than enough assets to cover the swaps, it couldn't sell them before the swaps came due. That left it without the cash to pay the swap insurance.
The Federal Reserve provided an $85 billion, two-year loan to AIG to further reduce stress on the global economy. In return, the government received 79.9% of AIG's equity and the right to replace management.
It also received veto power over all important decisions, including asset sales and payment of dividends. In October 2008, the Fed hired Edward Liddy as CEO and chairman to manage the company.
The plan was for the Fed to break up AIG and sell off the pieces to repay the loan, but the stock market plunge in October made that impossible. Potential buyers needed any excess cash for their balance sheets. The Treasury Department purchased $40 billion in AIG preferred shares under the Systematically Significant Failing Institution Program.
The Fed bought $52.5 billion in mortgage-backed securities. The funds allowed AIG to retire its credit default swaps rationally, saving it and much of the financial industry from collapse. The AIG bailout became one of the largest financial rescues in U.S. history.
The authors are grateful to the participants of the Grenoble Post-Keynesian and Institutionalist Conference ‘Instability, Growth & Regulation’ (Grenoble, December 2017) and those of the 22nd Conference of the Research Network of Macroeconomics and Macroeconomic Policies (FMM) ‘10 Years After the Crash: What Have We Learned?’ (Berlin, October 2018) for their fruitful comments and feedback. They are also grateful to two anonymous reviewers for their useful remarks on an earlier draft of the paper. This work has been supported by the European Research Council (European Union’s Horizon 2020 research and innovation program) under grant agreement No. 681337. The article reflects only the authors’ views and the European Research Council is not responsible for any use that may be made of the information it contains.
Bank of the Commonwealth
The first bailout of a too-big-to-fail bank was that of the Bank of the Commonwealth in 1972. Just eight years earlier, in 1964, Commonwealth was a mid-sized bank based in Detroit with $540 million in assets. That year, it was acquired by Donald Parsons and started to grow at an extraordinary rate.6 Between 1964 and 1970, its size in assets nearly tripled ($540 million to $1.49 billion). Part of Parsons’s growth strategy was to invest heavily in high-yield, long-term municipal securities with the hope that rates would drop and thus deliver a large capital gain. Commonwealth’s holdings of municipals rose from 7 percent of assets in 1964 to 22 percent in 1969.7 Unfortunately for Parsons, interest rates rose in 1969, and the value of the municipal securities plummeted.8
Parsons used wholesale funding markets to fuel his growth, but as funding problems developed, he tried to enter the international Eurodollar markets as an alternative (Sprague, 1986). However, the Federal Reserve, which was aware of Commonwealth’s poor financial condition, denied its application for a branch in the Bahamas. Application decisions are publicly released, so this denial revealed Commonwealth’s weakness to the market.
As a result, the bank saw its funding sources disappear, and it was forced to borrow from the Federal Reserve Bank of Chicago’s discount window to stay liquid. The bank’s borrowings reached a peak of $335 million in the summer of 1970 (Sprague, 1986).
Commonwealth was a large institution, with total assets of around $1.2 billion, and regulators were concerned that its failure would have serious consequences for the economy. The FDIC’s preferred course of action was to arrange a merger, but bank concentration in Detroit along with state banking rules limited the pool of acquirers. At the time, Michigan law prevented out-of-state banks from acquiring Michigan banks. However, the three largest banks in Detroit already controlled 77 percent of deposits, a situation which led FDIC Director Irvine Sprague to believe that the market would become too concentrated if one of them added Commonwealth’s 10 percent share (Sprague, 1986).
The FDIC decided to use its essentiality powers to bail out Commonwealth. It ruled that Commonwealth was essential because of its “service to the black community in Detroit, its contribution to commercial bank competition in Detroit and the upper Great Lakes region, and the effect its closing might have had on public confidence in the nation’s banking system” (FDIC, 1972). The final deal required Commonwealth to reduce the par value of all outstanding stock from $45.5 million to $7.9 million in order to absorb the losses from the sale of its municipal securities. The FDIC also lent the bank up to $60 million to replenish its capital (Sprague, 1986). While the FDIC’s assistance kept Commonwealth open, the bank continued to struggle after the bailout. The FDIC extended the loan in 1977, but Commonwealth never recovered fully and was eventually acquired by Comerica Bank in 1983 (Sprague, 1986).
Professor of Finance, RMIT, Australia
Imad A. Moosa
Authors Imad A. Moosa View author publications You can also search for this author in PubMed Google Scholar
The global financial crisis had massive and long-lasting implications for the stability of the financial system, the real economy, and society. In contrast with the COVID-19 pandemic, which was a global health shock that deeply affected the real economy and threatened to affect the financial system, the global financial crisis originated in the financial sector and spilled over into the real economy. Large and systemically important banks were at the centre of the crisis. Before the crisis, regulation of systemically important banks was inadequate: it did not set proper incentives to mitigate risks, and it did not provide a way to deal with risks that had materialized.
Addressing these shortcomings of the regulatory framework has been the objective of post-crisis financial sector reforms. Financial regulations have been overhauled in order to increase the resilience of individual financial institutions, to reduce moral hazard, and to prevent the build-up of systemic risk in the financial system.
This CORE Insight has focused on TBTF policies. It has:
- shown that the existence of banks that are too big to fail is an important and undesirable economic distortion, giving risk to moral hazard and systemic risk externalities.
- shown that a bank can be TBTF not only because of its size, but also because it is highly connected to other parts of the financial system. If systemically important banks experience losses and cannot absorb these losses, their failure can put the functioning of the financial system at risk: critical infrastructure such as the payments system may not function, and lending may be cut.
- discussed how higher capital requirements can increase the ability of banks considered TBTF to absorb losses, hence reducing the probability of their failure and the costs to the taxpayer in the event of their failure. Moreover, public authorities need tools to deal with failing banks without bailing them out or putting them into disorderly bankruptcy.
- argued that the effects and side effects of TBTF reforms need to be assessed from a social, economy-wide perspective. Effective TBTF reforms may mean higher funding costs for systemically important banks, because implicit funding subsidies decline. But this can have positive effects for society as a whole, as costs of bailouts decrease and as banks reduce their risk-taking. Effective TBTF reforms may mean that systemically important banks have lower market shares. But this does not necessarily mean less funding for the real economy because other financial institutions pick up the business.
Overall, the case is not closed. Indicators of bank behaviour and systemic risk have moved in the intended direction, and public authorities now have the tools to deal with failing banks. But we cannot really know whether a bank is TBTF until it fails and we see how the authorities deal with it. Solving the TBTF problem is an ongoing project. Regulations addressing systemic risk externalities have to be implemented and enforced. Other financial intermediaries have entered the scene, and non-bank financial intermediation has gained in importance. Even if the TBTF problem has been mitigated in the banking system, it could arise in the non-bank financial sector. Addressing TBTF risks and monitoring risks to financial stability therefore remain a priority.
The Bottom Line
To protect the U.S. economy from a disastrous financial failure that also might have global repercussions, the government may step in to financially bail out a systemically critical business when it is failing—or even an entire economic sector, such as transportation or the auto industry.