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Too Big to Fail

In this essay I will be addressing the “Too Big To Fail” (TBTF) problem in the current banking system. I will be discussing the risks associated with this policy, and the real problems behind it. I will then examine some solutions that have been proposed to solve the “too big to fail” problem. The policy ‘too big to fail’ refers to the idea that a bank has become so large that its failure could cause a disastrous effect to the rest of the economy, and so the government will provide assistance, in the form of perhaps a bailout/oversee a merger, to prevent this from happening.

This is to protect the creditors and allow the bank to continue operating. If a bank does fail then this could cause a domino effect throughout the economy, i. e. bigger companies often purchase supplies through a smaller company who rely on the bank for a large portion of its income, the bank’s failure could then cause them to shutdown, meaning unemployment. So what the regulatory bodies need to decide is what is the more economically viable solution in the long run.

The Governor of the Bank of England recently stated that ‘if a bank is too

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big to fail – it is too big. From 1929 – 1933 the US banking system failed and this caused one of the greatest economic recessions in history. During this period banks were allowed to fail as there was no regulatory body (Federal Deposit Insurance Corporation), no protection of depositors, and no real mechanism for an orderly dissolution of the existing management and transfer of what was valuable to a new, stronger bank. Friedman, Heller (1969 pp. 79-80) states that “We did learn something from the Great Depression… We learned that you ought to have numbers on the quantity of money.

If the Federal Reserve System in 1929 to 1933 had been publishing statistics on the quantity of money, I don’t believe that the Great Depression could have taken the course that it did. ” Meaning that a stricter set of regulations was needed for the entire banking system. In 1988 the Basel I accord was introduced as it was felt that financial institutions were not retaining sufficient capital. The Basel I accord aimed to provide recommendations on ‘minimizing credit risk by creating a bank asset classification system’. This considered the risk of borrowers not being able to keep up with repayments.

The Basel I accord became outdated with the advancement of the financial system, and so a modified set of guidelines were required. This took the form of the Basel II accord, introduced in 2004, and its role was to ‘create standards and regulations on how much capital financial institutions must have put aside’. [ 4 ] Putting money aside is essential to reduce the risks associated with the bank’s lending and investing activities. A prime example of a financial institution that was too big to fail, comes from the recent financial crisis, Bear Sterns of Wall Street.

On March 16th 2008 the American Federal Reserve oversaw the buy-out by J P Morgan Chase, this move was seen as essential in ‘an unprecedented move to prevent the implosion of the US financial system’ (Jagger, Kennedy 2008). The financial crisis of 2007-2008 was by some measures the worst in the entire history of market capitalism, its cause stems from many different areas, the too big to fail policy poses many problems to the economy. In particular, moral hazard.

This is the tendency of a “too big to fail” firm to make ‘bad loans based on an expectation that the lender of last resort… ill bail out troubled banks’ (Liu 2008). It’s when the bank makes a bad investment, but suffers none of the consequences. This means that banks feel they are “protected”, so they may take on investments of higher risk than they would without this protection. This in turn increases the risk of a Central Bank (e. g. Federal Reserve) having to make a bailout. There is much risk associated with “too big to fail”; Credit risk, also known as default risk, is the name given to the investors risk of loss on an investment.

This loss is caused by borrowers defaulting on their payments, for example, not making a mortgage loan payment. Market risk is the risk associated with an investors day to day investments, that are affected by constant fluctuations in the markets. With investment banking, a banks reputation is a critical in its success, reputational risk describes the trustworthiness of a business. A firm with a poor reputation will not get as much business, meaning a bad reputation results in a loss in revenue.

Concentration Risk is the risk showing the spread of a banks’ accounts to various debtors to whom the bank has lent to. The Basel II accord stated that ‘operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events’. This risk covers the very wade basis of a company’s operations, there are many different factors involved here: people, employees actions and company processes. Systemic Risk is the risk of the collapse of the entire financial system, Kay (2008) defined it as ‘the endency for the failure of a financial services business to have an impact on many other businesses. ’ [ 16 ]

The key to solving the problem of systemic risk is by naming and taxing the TBTF firms and this will minimize systemic risk and it will level the playing field for firms who do not have the same guarantee of financial support as TBTF firms do. During the recent financial crisis, in the autumn of 2008, the Lehman Brothers bank collapsed. It was the biggest bankruptcy in history and this effectively triggered the “credit crunch”.

Overnight, the amount that banks charged each other for short term loans doubled, the banks simply could not afford to borrow money and therefore banks lost confidence in banks. The essence of a bank is confidence, depositors must have confidence in a bank for banking to work, to get them to deposit, to allow banks to lend to family’s and other institutions. However, this crisis did not turn into the new Great Depression but this was due to ‘exceptional policy responses were taken to prevent a banking system collapse’ [ 2 ] (Turner 2009).

From this crisis, it was obvious that policies and regulations had to be re-assessed. On the 4th March 2008 at the Risk Minds Asia Conference the chairman of the Basel Committee stated “… most global banks are only beginning to implement the Basel II framework as of the beginning of this year. The financial turmoil therefore has been playing out under the Basel I capital regime. ” (Wellink, 2008). With hindsight, this should have been different, the new Basel II accord should have been implemented more quickly to the bigger, “too big to fail” banks.

Banks that are deemed TBTF are given direct support by the government, solutions must be devised to prevent stop this from happening again, the point of moral hazard is raised again here. A bank may take on riskier business as it has the insurance of the government, ‘too big to fail is the cancer of moral hazard’ [ 6 ] (Lui, 2008). The too big to fail problem could be resolved in a number of ways, in a recent interview with Andrew Ross Sorkin, a columnist at the Financial Times, he said that the key to regulatory reform was ‘Resolution Authority… nd… Higher Capital Ratios’. The Lehman Brother’s bank was deemed too big to fail, and it did fail. Its collapse acted as the ‘domino that cascaded throughout the system’ (Sorkin, 2009).

This company went through the bankruptcy process and this meant that all of these funds were tied up in bankruptcy court. The acting regulatory body should have taken over the companies ‘capital requirement’ in the resolution period (the period just before a firm starts to become insolvent) and by using it at the correct time, stop the bank from becoming insolvent. Resolution authority is a relationship between deterrence, detection and resolution’ (Konczal, 2010). Resolution is the point where regulators can see that the companies figures are looking poor and so they can ‘demand that financial firms raise more capital, divest of certain business lines, make themselves less interconnected. ’ [ 10 ] This action taken is essential, as a “too big to fail” financial institution, that is on the verge of bankruptcy, is far more likely to take on riskier business deals in the hope that they pay off, however if the gamble doesn’t pay off, it is left as a cost to the real economy.

This is the method used by regulatory bodies with commercial banks, regulation creates limits and higher capital ratios, then if the bank did fail, then the government will detect it (as it is monitoring them) and this in turn acts as a deterrent. Another proposed solution to the problem is a Centralized OTC settlement, (OTC – ‘over the counter’ is a term describing the trading of securities not at an organized exchange). Flannery (2009) stated that ‘encouraging banks to settle standard derivatives contracts on a centralized exchange will eliminate a lot of credit risk from the financial system’.

The problem being at the moment is that there is no way that regulators can observe this risk. Banks trade using market information. Another solution could be to tie some supervisory actions to market information, this involves limiting the time taken for a supervisory body to step in and take assertive actions against individual firms. [ 11 ] This will address the problem of banks functioning incorrectly due to, for example, very high leverage. Flannery (2009) suggested that ‘by keying regulatory actions to market ratios, supervisory delay can be reduced and bank distress sometimes avoided’. 11 ] It has been suggested that Higher Capital Ratios are key in the “too big to fail” problem. Higher capital requirements are crucial, money is needed physically in the bank, ‘capital is the generic guarantor, good for protecting fixed creditors from any type of loss and hence avoiding disruptive bankruptcies’. [ 11 ] For this to be implemented, the enormous profits and oversized bonuses that are declared by a systemically important financial institution, must be pumped back into the bank. In the short term, depositors won’t get the lending they want.

However, in the long term the bank grow to be more secure and stronger because of it. Raising Capital Requirements and limiting leverage are essential to provide a secure and effective solution, these two combined have the strong potential of being actual solutions to the problem. However, there are downsides. These will essentially cap profitability, and the institutions concerned clearly will not agree with this. At present these solutions are not even being put to use in the regulatory reform, perhaps discretion is the better form of political cowardice.

In a recent article by the President and Vice President of the Federal Reserve of Minneapolis it was stated that ‘if financial institutions raise systemic concerns because of their size, fix the TBTF problem by making the firms smaller’. This would be done by “chopping up” the bigger firms into smaller ones. To make sure that a bank isn’t too big to fail, it cannot be allowed to get too big. The interconnectedness of these institutions is vast and this means, as mentioned earlier, the failure of one part could cause a complete collapse.

Making the firms smaller seems to be quite a sensible and easy way of approaching this, ‘but in fact it provides only a false sense of security that may lull policymakers into inaction on other fronts’. [ 12 ] There is a problem in that it is often assumed that only larger firms pose significant systemic risk, however, small firms do as well, and “splitting them up” based on their size wouldn’t be applicable to a smaller firm. Such a straightforward method clearly isn’t the complete answer.

Northern Rock’s collapse is a perfect example of this, it was a small firm that posed a very high systemic risk, that failed; and breaking it up wouldn’t have solved this. The bottom line here is that a financial institutions likelihood to fail isn’t solely dependent on its size. Even if the firms were broken up and policy makers were able to keep them small, there would be ‘nothing to prevent firms from engaging in behaviour in the future that increases potential spillovers and systemic risk’. [ 12 ] The problem is the concentration risk; fewer and larger financial institutions in the financial markets are increasingly interconnected.

Not breaking up these large institutions will require more intrusive and more complex regulations which in turn could lead to uniformity of models, structures and strategies, exacerbating the concentration risk. Increasing model risk (risk in valuing financial securities) twinned with increasing concentration risk results in exponentially higher systemic risk. Breaking up banks and categorizing the risks may not be an ideal solution, but it seems to be a better solution than being exposed to a huge concentration risk, which increases the external costs of a failure of the financial institutions.

Increasing these plus external costs creates an almost certain need to bailout financial institutions in a crisis, which in turn increases the risk of moral hazard. Avoiding the failure of one or several institutions in the first place, would require a regulatory authority which is blessed with the gift of perfect foresight and the capability and authority to take the correct countermeasures at the correct point in time. Another potential solution is to limit the number of volatile investments that financial institutions partake in.

Systemically important financial institutions should be prohibited from trading securities for itself and more focused on trading securities for its clients, and ‘from holding large volatile investments like hedge-funds or private equity funds’. [ 11 ] Hedge-funds are sums of money generated by ‘high risk investment strategies including arbitrage and short selling’. The problem with hedge-funds is the high risk investments that create them, when these investments pay off, things are fine, the gamble paid off. However, when they don’t this can lead to major problems for the company, as if the gamble is sizeable enough and doesn’t pay off… ankruptcy, or a bailout at the expense of the taxpayer.

Therefore, “too big to fail” institutions should not hold them. Living Wills are another possible solution, that could potentially put a stop to moral hazard and‘force banks and regulators to organize themselves so that it is easier to dismember systemically important firms in a crisis. ’ A living will would make it less likely for a systemically important bank to need intervention and resolution plans will lower the impact on society, if intervention is required. Narrow Banking is another possible solution.

It is effectively an update of the Glass-Steagall Act (which required the separation of commercial banking and investment banking), and it involves the ‘separation o f utility from casino banking’. Narrow banking is the envisioning of an entirely new banking system where the focus is on national and international payment systems, for institutions of all sizes, and on deposit taking from small and medium institutions. [ 16 ] Narrow banking eliminates the costly distortion of competition, for example with the Icelandic banks that had ‘poor quality lending books’ and unfairly competed with UK institutions, at he expense of the taxpayer. [ 16 ] With the implementation of narrow banking, this wouldn’t happen again.

Narrow banks also ‘make their own decisions guided by the availability and price of funds, as to the equity capital needed to support their lending’. [ 16 ] Narrow Banking seems to be a viable option, however, recently Adair Turner said: ‘The extreme narrow banking proposal is clearly doable in practical terms, but it could produce a financial system even more vulnerable to instability than the one we have today. The ‘new Glass Steagall’ seems to be quite a good idea but, perhaps the best way to go about is still ‘through the capital requirements we place on trading activities’ [ 17 ], and not just writing a strict law of what can and cannot be done. Completely rejecting the possibility of regulation solving the problem is perhaps quite narrow minded. In conclusion, banks are essential to the economy. The “Too Big To Fail” problem has to be resolved, to prevent financial crisis’s happening over and over again.

The failure of TBTF institutions has too many repercussions on the rest of the economy and small firms that are dependent on it. Perhaps the problem of a bank being too big is not what should be resolved, in fact it is their attitude that they can do whatever they please and not suffer any consequences, instead the taxpayer foots the bill. With Non-systemic banks that fail the debt capital providers suffer a loss, this should be the same for Systemic banks, they should not have the insurance of the government.

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