Too Big to Fail
The term Too Big to Fail came into the banking industry when Continental Illinois National Bank and Trust Company, the USAs seventh largest bank failed in 1984 as a result of relaxed policies and supervision. The government failed to correctly asses the riskiness of the financial institutions. In order to pursue a growth strategy the bank had undertaken massive lending and its debt to assets ratio increased dramatically from 57.9 in 1997 to 68.8 in 1981. As the situation continued to deteriorate the bank regulators faced with a potential threat that a crisis might envelope the entire banking system provided aid to Continental. FDIC provided 1.5billion, the Federal Reserve promised any monetary assistance required and 24 major US banks lent 5.3 billion on unsecured basis as a permanent solution was sought (Federal Insurance Deposit Corporation 5-10) The term has come to imply that the economic repercussions of liquidating a financial institution that is too big in size or interconnected is so devastating to the economy that these institutions are provided help by government bail-outs and taxpayer stimulus plans.
Alan Greenspan, the former Chairman of Federal Reserve believes that the Too Big to Fail doctrine is dangerous because it provides financial institutions to undertake reckless and risky behavior as they come to believe that they will be bailed out by the government and undertake riskier investments and increase their systematic risk (qtd in Noah n.p) However, this doctrine can have adverse affect in terms of GDP also. Without strong regulatory control of TBTF institutions, many economists believe, smaller hanks will be squeezed even more, depriving entrepreneurial companies of the money needed to transform a jobless uptick in GDP into a sustained rebound (Rosta 01).
Several financial companies that were not traditional banks were deemed too systematically important to be allowed to fail through the normal bankruptcy route. Too big to fail is a bit of a misnomer. The issue is better explained as too interconnected to fail. A financial institution is a business a business is just an experiment in the game of capitalism and it is in the nature of experiments to fail. Our regulators goal isnt to make a system in which there are never failures but a system in which failures are cleaned up in an orderly and non disruptive fashion. Like an elaborate game of Jenga, even removing the smallest piece can collapse the entire structure, and regulators need to be able to remove any piece without having the entire real economy collapse.
There are two ways the current legislation approaches this task first, regulators will keep firms from becoming too risky as a proactive measure second, the legislation will make it easier to resolve a financial institution when things do fail. The bill will create a Financial Oversight Council, consisting of the major government regulators that will determine in advance which nonbank institutions will be designated Financial Holding Company Tier 1 and fall under the umbrella of heightened scrutiny. These are the potential TBTF firms (Konczal n.p)
The AIG presents another case of the too big to fail gone bad. AIG was bailed out by the government and provided 170 billion in taxpayer bail-out to the ailing firm specially one of its units AIG Financial products which piled up a huge amount of toxic and non performing loans costing 40 billion due to dealings in the mortgage bond derivatives. The firm did not stop its reckless behavior and the last straw which was the cause of all hell breaking loose on Wall Street and Washington was the discovery that AIG had paid its executives 165 million in retention bonuses to the AIG Financial Products unit that had been recently bailed-out. The idea is that in a global economy so tightly linked that problems in the U.S. real estate market can help bring down Icelandic banks and Asian manufacturers, AIG sits at some of the critical switch points. Its failure, so the fear goes, would set off chains of others, rattling around the globe in short order. Although some critics say the fear is overblown and the world economy could absorb the blow, no one seems particularly keen on testing that approach (Saporito n.p)
By failing to provide bail-out money to Lehman Brothers the Federal Reserve sent a signal to other too big to fail firms that it was a consequence of moral hazard and that Uncle Sam will not bail out financial institutions always. However, as this decision took the market down with it with US stocks declining and the economic recession looming large, the Federal Reserve and the Obama Administration did not think it would be too wise to repeat the same with Bear Sterns and AIG which were provided the money to get rid of toxic loans and sell non profitable units to cover up the mess.
Fannie Mae was created in 1938 during the administration of President Franklin D. Roosevelt when millions of families couldnt afford to buy a home. Freddie Mac came along 32 years later.The two institutions were chartered by Congress as government-sponsored enterprises and had an implicit guarantee from the government that they would not fail. Now we see that the implicit guarantee has become an actual guarantee. In 2007, the two companies reported a combined loss of just under 5.2 billion, according to a Congressional report. Until then, they had not reported a combined loss since 1982. To prevent a crushing blow to the housing market, the federal government stepped in to bail the companies out.
Fannie Mae and Freddie Mac are so large and so interwoven in our financial system that a failure of either of them would cause great turmoil in our financial markets here at home and around the globe, said Secretary of the Treasury Henry Paulson, quoted recently in The Wall Street Journal Fannie Mae and Freddie Mac, which are government-backed lenders for mortgages, hold 5 trillion in securities backed by American mortgages.
The main solution to this problem is that no company should be allowed to be too big to fail. The firms who are too big to fail dont increase their size so that they will be more profitable or better than their counterparts. Growth objective at one stage supersedes the desire and greed that they will be so huge and interconnected that even if they undertake risky behavior the government or other financial institutions will bail them out and will not let them fail. These too big to fail firms also form factions and lobbies among the political elite and can easily exploit difficult times through their relations to the upper echelons of the society and government. Te government can also net step out on the last moment because it will cripple the economy as it did in case of the Lehman Brothers. Such firms should not exist. The government should make sure that firms maintain a limited size and operations and if they are truly growing their operations are monitored and the higher management is accountable for all their decisions not only to the shareholders but also to the government because ultimately it is not the shareholders who have to inject billions of dollars to provide and sustain the ailing organization. Its the Federal Reserve and the taxpayers who have little or nothing to do with these companies and their toxic assets and reckless behavior.
Too big to fail creates a moral hazard when it comes to rely too much on taxpayer bailouts and stimulus packages to rescue it from billions of dollars of systematic risk. At this point the regulations that were put in place to keep a check have to be revised since it is pretty evident that they failed to work and keep a check and balance on things and let things run out of hand in the first place. With these regulations rectified, the government should ask financial institutions to keep a higher amount of capital and equity to fulfill their short-comings instead of completely relying on aid and investing too much in risky assets. The more the amount of systematic risks these firms undertake the higher their special capitalretained earnings or any other contingency fund should be in order to meet the losses from toxic assets.
This situation has also brought to limelight and emphasized the fact that risk-management was not given due importance in the too big to fail institutions and every risky decision was masked behind promises of high returns and superior growth ultimately leading to increased share price and market capitalizations. This failure of banks and financial institutions as a risk manager has terribly failed leading to a domino effect across all their units leading to either bankruptcy or mergers to sustain themselves.
Market discipline is also an important factor if we want to avoid such financial meltdown and collapses in the future. The market can be disciplined when the investors and creditors avoid risky behavior by correctly forecasting the prospect of bad debts. This would provide regulators with an instant picture of whether to conduct business with the firm or not. The higher management of the firm should ask its financial regulators to make up a plan which would present a worst case scenario to the management and the management can compare its actual and estimated performances and follow up to the benchmark to see where it stands. This will immediately discipline it that they should not undertake anymore of the systematic risk investments because if they do they run a risk of losing their sustainability and becoming financially weak themselves.
At this point, the solution that would be most effective immediately is market discipline. Market discipline will require investors and creditors to clearly asses their long term liabilities and goals and not get carried away with moral hazard. If they are not disciplined they run the risk of facing the same fate as Bear Sterns did by being either acquired by some company and losing their market reputation, credibility and identity altogether or they might be rejected by the Fed and other institutions for bailout money which would immediately lead to bankruptcy therefore market discipline is very important. The other two options should also be looked into in the future to provide maximum insulation and care to the economic and financial system so that it does not render thousands jobless and lose their credibility as a risk manager and optimizer of deposits and peoples money.