Last Updated 27 Mar 2020

Too Big to Fail

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Can banks become “too big to fail”, and should they be allowed to stay that way? On September 15th 2008, the investment bank Lehman Brothers filed for bankruptcy. It was, and still is, the biggest bankruptcy filing in U.

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. history , with Lehman’s holding $691 billion in assets at the time. The event was the catalyst for the current financial crisis.

By the end of trading that day, $700bn had been wiped off the global stock markets. The Dow Jones had plummeted 500 points, its biggest drop since the terrorist attacks of 9/11 . Despite rumours and knowledge that Lehman’s was struggling, with its share price dropping daily, the huge drop in the financial markets was due to the huge shock. No-one had been expecting this, as it was anticipated that the U. S. overnment would intervene and bail out the bank, as it had done previously for another investment bank Bear Stearns, and for the mortgage firms Freddie Mac (Federal Home Loan Mortgage Company) and Fannie Mae (Federal National Mortgage Association) earlier on in that month. Everybody had assumed that Lehman’s was simply too big to fail. The term “too big to fail” has become a phrase used to describe banks that are so interconnected, so large and so strategically important that if they were to fail the consequences could be catastrophic for the economies they inhabit .

In November 2011, the Financial Stability Board released a list of 29 banks worldwide that it considered to be too big to fail, and gave its definition as “systematically important financial institutions are financial institutions whose distress or disorderly failure, because of their size, complexity and systemic interconnectedness, would cause significant disruption to the wider financial system and economic activity” . There is an intense debate as to whether banks should be allowed to be too big to fail or not.

Those in favour consider the idea that those institutions that are too big to fail should be given special status by the governments and central banks. They also think the institutions should be the recipients of special protective policies that shield them from legislation that may harm them. On the other side, there are a lot of critics of the “too big to fail” train of thought. One of the main issues is the moral hazard problem that arises. If the banks know that the government will bail them out once they start to get into financial difficulties, then they will seek to profit from it.

They will take higher and higher risks, and act more dangerously as they know they have a safety net to fall back upon. Opponents argue that if an institution is too big to fail then, instead of protective policies being gifted to it, much stricter regulations should instead be applied to prevent bankers from taking too many risks. Some go as far as to suggest that if the bank is too big to fail, then it is simply too big, and should be broken up. Proponents of this idea include Alan Greenp, former Chairman of the Federal Reserve , and Mervyn King, the Governor of the Bank of England .

Others suggest that no bank is too big to fail, and if it gets to the stage where a bailout is required then the bank should just be forced to go into liquidation. This topic is so interesting because of its massive impact upon the global economy at this current time. The sub-prime mortgage crisis, the collapse of many financial institutions and the massive levels of government bailouts have dominated the political agenda for the past four years or so, and are one of the causes of the recession we currently find ourselves in.

Whilst rather outnumbered by the number of critics of too big to fail ideas, there are nevertheless a large number of people who consider that banks should be allowed to be and to become too big to fail. One area that they point to as a real asset is the sheer size of the bank itself. Being so large, they can conduct large financial operations using enormous sums of money. This allows them to provide more services, and to more people, than smaller banks. They can also lend in developing, growing countries, which often don't have strong financial institutions of their own.

Furthermore, their size and capital allows them to provide those services at cheaper rates than their smaller counterparts. The large banks can achieve much greater levels of economies of scale. Studies by Boyd and Heitz have shown that larger banks, (defined as having assets of over $50 billion), have higher scale economies than their smaller counterparts . The mean measure of scale economies in the banking industry is 1. 145, whilst the larger banks had a mean of 1. 25, implying that they were therefore 9. 2% more efficient than the rest of the industry.

They hereby estimated that the larger banks’ economies of scale increased their contribution to national output by 9. 2%. These proponents argue that the social benefits derived from these economies of scale are beneficial enough to prevent the stricter reforms and changes being discussed by governments around the world from being implemented. One of the main arguments against banks becoming too big to fail is that a moral hazard problem occurs. Moral hazard is a basic economic concept, whereby one party entering a transaction will take more risky actions if they know they have insurance against the outcomes of those actions.

At present, too big to fail banks have a variety of systems emplaced by the government, which protect them in the event that they run into financial difficulty. For example, in the U. S. the banks’ creditors get federal deposit insurance, which guarantees the deposits of bank creditors up to a certain amount in the event of bank failure , and this is just one of many. When the sub-prime mortgage struck in 2007 bankers and financial institution were undertaking very risky ventures and even fraudulent activity. KPMG’s study, “Who is a Typical Fraudster? found that the most likely type of person to commit fraud was “A 36- to 45-year-old male in a senior management role in the finance unit or in a finance-related function” . One example, a loan was issued to a “sales executive” for Bay Area Sales and Marketing earning $8,700 per month for a $398k loan on a house which was worth no more than $277k, and the “executive” had been unemployed since 1989 and had no income. Another example was a loan application form filled in for an investor for GNG Investments in Santa Clara California turned out to be a janitor making $3,901 per month.

She got a house worth at the time $600k. The lack of regulation made it very easy for financial institutions to play fast and loose with their investments and projects. Goldman Sachs, the investment bank, is currently fighting a fraud suit brought about by the U. S. Securities and Exchange Commission (SEC) . They are accused of creating and selling a mortgage investment that was secretly designed to fail. Lehman Brothers has been accused of accounting fraud, by removing debt off its balance sheet to make it appear less leveraged, despite a massive leverage ratio of at times up to 40:1.

Ernst & Young, Lehman’s auditors, have since been sued by the New York Attorney General Andrew Cuomo . British banks too have been accused of misreporting. Northern Rock’s former deputy chief executive and former managing credit director were fined by the Financial Services Authority (FSA) for deliberately misreporting its mortgage arrears figures . If properly reported, the bank’s arrears figures would have reached 50%. These banks could behave in such a way because of the attitude of the U. S. overnment and other governments around the world - they knew they would receive public funding if things went badly wrong for them. Opponents of too big to fail banks are split into three main camps, those who think the banks need tighter regulation, those who believe they should be broken up, and those who think the banks should simply be allowed to fail. The most common line of thought is for tighter regulation, and it is not just politicians and other senior people who voice that opinion, most of the world seems to have been voicing it recently.

Due to their reckless spending and playing of the markets, it is argued that the banks’ social costs far outweigh their social benefits. The fallout from the collapse of too big to fail banks is far greater than the benefit they bring from their large economies of scale. In 2009 the International Monetary Fund (IMF) has estimated the total cost of the global financial crisis to be around ? 7. 1 trillion . Boyd and Heitz estimate the social cost is around 40% of 2007 real per-capita GDP, and that the costs are far larger than the benefits .

Increased regulation of banks that are deemed too big to fail would prevent the reckless behaviour seen leading up to this current crisis. There are many different ways of increasing the regulation being discussed as possible options, and some are being implemented. This is despite the vast lobbying efforts levelled at Congress by the banking industry (during reform debates, banks spent an estimated $1. 4 million per day to influence Congress) . One is the required increase in the minimum level of capital that banks hold.

When the crisis hit, many banks had very high leverage ratios, the average being in the high twenties, with Lehman’s hitting around 40:1 at times. In June last year, the Group of Governors and Heads of Supervision (GHOS), the oversight body for the Basel Committee on Banking Supervision (BCBS) introduced legislation requiring banks to have additional levels of capital from 1 – 2. 5% depending on the bank’s systematic importance . Tighter regulation on banks’ liquidity levels is another area proposed, as is more regulation on “shadow banking” activities. Shadow banking” refers to financial institutions that fall outside the definition of a bank, for example hedge funds and structure finance vehicles (SFVs). In the U. S. , the ‘Dodd-Frank Wall Street Reform and Consumer Protection Act’ was introduced in 2010. This has created a new independent financial watchdog, (The Consumer Financial Protection Bureau); prevents future bank bailouts; eliminates loopholes that encourage risky ventures; brings in an advanced warning system for systematic risk and generally reinforces bank regulation. It is hoped throughout the U. S. hat it is legislation such as this which will prevent future crises from occurring. A key proponent of increased regulation is the Nobel Laureate Paul Krugman, who believes that the economies of scale are worth keeping, and that all that is needed is tighter regulation of both the banking system, and the “shadow banking” system . He says it is easy for people to point the finger at the size of vast banks and use a “greed culture” as blame for the crisis. He argues that it is not necessarily the size of the bank that is important; it is the interconnectedness that matters .

These thoughts backed by Chen Zhou of De Nederlandsche Bank and Erasmus University Rotterdam, who used experiments to show it is the systematic importance, rather than the size of the bank which mattered . Another method proposed by opponents of too big to fail banks to deal with the problems is to deliberately break them up. This refers in particular to investment banking groups with commercial arms. In the U. S. , where there is more focus on dealing with the problem through increased regulation and legislation. In the UK, however, the argument is less settled.

Whilst there are some proponents for bank separation in the U. S. , such as Alan Greenp, quoted as saying “If they’re too big to fail, they’re too big” they are fewer than in the UK. Mervyn King is one, saying “It is not sensible to allow large banks to combine high street retail banking with risky investment banking or funding strategies, and then provide an implicit state guarantee against failure” . He wants banks broken up so that the separate parts can be much more highly capitalised. Sir John Vickers’ Independent

Commission on Banking has been under pressure from politicians such as Vince Cable to conclude that the best course of action is to break up the larger banks. There are a lot of opponents to this idea, however. The main issue is where you draw the dotted line. Most banks don’t split into two convenient easy sections, it is all very intertwined and the line between investment and retail can be very blurred indeed. As Damian Reece, the Head of Business for the Telegraph says, “the boundaries between retail and investment banking are extremely blurred, if not invisible” .

A possible compromise may be to make banks separate the operations internally, and then regulate them in that state. Lord Turner, the Chairman of the FSA, has recommended such a course of action in the review he carried out of the banking crisis . The review notes, “It does not therefore seem practical to work on the assumption that we can or should achieve the complete institutional separation of ‘utility banks’ from ‘investment banks’ which the advocates of that model suggest”.

The last option is the most extreme one, whereby supporters propose that if a bank runs into trouble it is simply allowed to go bankrupt. Alton Drew, an independent policy analyst, is quoted as saying, “We should allow big banks to fail because ‘market stability requires it’” . However, I disagree with this idea. The collapse of Lehman Brothers is, in my opinion, a good example of the dangers of letting a bank fail. Whilst many people think that Hank Paulson, the then U. S.

Treasury Secretary, deliberately let Lehman’s collapse to send a message to the banking industry, he and others involved have stated that it was just untenable to bail out Lehman Brothers. Paulson said, “I never once considered that it was appropriate to put taxpayer money on the line in resolving Lehman Brothers” and Neil Kashkari, the then Assistant Treasury Secretary justifies this: “The law requires the fed to be secured so that they’re not taking much risk. And so in the case of Bear Stearns, they lent $30bn against a pool of mortgages. In the case of Lehman Brothers, the question is what asset could they lend against” .

However, many believe that Lehman’s was too big and too interconnected to let fail, and that the fallout from this has been far worse had it just been bailed out. John Thain, former CEO of Merrill Lynch said, “I believe that allowing Lehman Brothers to go bankrupt was a tremendous mistake. The amount of money it would have take, $20bn, $30bn, compared to the destruction in value that followed the Lehman bankruptcy, and the complete shutdown of the credit markets, the billions and billions and billions of losses that were experienced in the markets subsequently” .

In conclusion, it is my opinion that banks can be too big to be allowed to fail, as seen in the example of Lehman Brothers. As Mervyn King said, “I don’t think any of us easily anticipated the kind of financial crisis we saw after the collapse of Lehman Brothers” and think that with hindsight, the U. S. Treasury and Federal Reserve would think a lot harder if they could go back and make that decision again. I don’t think that it is necessarily a bad thing for banks to be too big to fail.

The economies of scale, and the vast wealth and expertise generated by these banks can be very beneficial to an economy. If full and proper regulations and legislation are put into place, the moral hazard that arises from the knowledge of guaranteed bail outs will cease, and so the social negativities generated will be greatly diminished

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Too Big to Fail. (2017, Jan 24). Retrieved from https://phdessay.com/too-big-to-fail-185048/

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