The too-big-to-fail problem refers to the issues that arise when a large bank is so pivotal to the financial system, that its failure would be detrimental to the entire economy. But how has this problem come about? And what can realistically be done to combat this ever-present issue? This article attempts to answer these questions as well as exploring evidence this problem exists such as the government bailout of RBS.
What is it?
As previously mentioned, the too-big-to-fail problem comes down to the systemic importance of large banks, and how they become so important that their failure could inflict major damage on both the financial system and the wider economy. The enormous costs associated with the failure of a large bank or financial institution motivate changes in policy to try and prevent a failure occurring. While the cost of ‘bailing out’ (using public funds to avoid failure) a bank can be massive, the effects of a bank failure can be much more costly. The general consensus is that large banks failing can lead to contagion effects. This occurs when one bank suffers troubles and potential failures which can in turn affect another bank through the interbank market, which can consequently lead to deterioration across the entire financial system. Commercial banks can also suffer consequences from bank runs, where depositors look to withdraw cash due to a lack of confidence, leading to liquidity shortages. It is argued that these effects should be avoided at all costs, hence the idea that large banks are too-big-to-fail.
What is the problem?
The problem with having banks that are viewed as too-big-to-fail is the creation of moral hazard. This is the economic idea that an individual or entity does not have to bear the costs of their actions. These too-big-to-fail banks have an incentive to take on more risk since the government won’t allow them to fail. This benefits the banks as they have a greater potential return from their investments. However, if their more risky investments were to backfire, the resulting extreme losses would be destructive for the government and the economy, who would have to pay for the bank’s mistakes. This situation shows how the assumed-protection of too-big-to-fail banks at the expense of the government may actually lead to financial instability in the long term.
How has it come about?
The term ‘too-big-to-fail’ was first coined during the failure of Continental Illinois (a US commercial bank) in 1984. The bank has extensive relationships with both retail and corporate clients meaning that a bailout was almost inevitable once the bank had found itself in financial difficulty.(1) This pushed forward the too-big-to-fail problem to the forefront of financial regulatory debate. Since then, there has been greater availability of credit in the 1990s and an increased diversity of services offered which has enabled tens of banks to grow in size and be considered too-big-to-fail. (2)There have been difficulties in solving this which has furthered the extent of the issue, as a lack of effective action means the problem worsens as time goes on.
How do we measure it?
The size of a bank is unsurprisingly the main characteristic used when determining whether or not it is considered too-big-to-fail. Although there is no universal threshold, the US has formulated legislation to give a strong insight into whether or not a bank or financial institution should be classified as such. The infamous 2010 Dodd-Frank Act characterised a systemically important financial institution as one with over $50bn in assets. When this was introduced in 2010, this meant that there were 38 banks operating in the US who would be considered too-big-to-fail, although this threshold has since increased. (3)It is clear that there are numerous banks that could wreak havoc for the financial markets if they were to suffer failure. Although it is a useful indicator, there are other factors to consider rather than just taking into account the overall size of the banks or financial institution. Though it is difficult to measure, the influence that a bank has should also be considered, especially when some institutions are more heavily entwined in the commercial banking sector.
RBS – A case study
The UK government bailout of RBS in October 2008 is a prime example of a bank being too-big-to-fail. For a short period, RBS was the biggest bank in the world by assets.(4) Thus, it can be understood why the government felt it was necessary to bail out the bank when it found itself in financial trouble. The reasons behind this financial trouble really highlights the assumed nonchalant attitude of too-big-to-fail banks. Although there are a plethora of reasons for RBS’s failure, the bank's showed a strong willingness to take risks which just emphasises the moral hazard at the time. It is possible that the need for a government bailout came as a consequence of this moral hazard, created from this idea that the bank was too-big-to-fail. The case study of the failure of RBS highlights not only an excellent example of how the actions of too-big-to-fail banks lead to their failure, but also shows how the government reacts to this failure.
With a contentious topic like this, there is much debate about what possible ways there are to solve the issue (if there are any at all). One suggested solution to come to mind may be to put a cap on bank size. However, this does not come without its issues. Choosing the right level at which to impose the cap would be a near-impossible task and would cause further debate and potential issues amongst some of the banks near the proposed cap. Another issue with a size cap is the effect on banks who may be caused to narrow the range of services which they offer as they are forced to meet the new requirements. This could be an issue to the bank's customers, not just the bank itself, who could experience hardship as a result of decreasing revenue streams.
An alternate remedy to the too-big-to-fail problem may be to enhance the financial regulation of large banks. The idea being that this may reduce the level of risk that a bank chooses to take and therefore potentially decrease the risk of failure. This idea is not without its problem either as it could be very costly to put in place. The estimated cost of regulation in the UK is around £1.9bn, considering the strain that the COVID-19 pandemic has had on public finances the government would not be keen on such a figure, particularly when results would not be guaranteed. (5)
Evidently, it is clear that even the most popular solutions to this ever-growing problem have limitations.
To summarise, the too-big-to-fail problem will only grow in correlation to these banks also growing, and little to nothing is done to remedy the situation. The issues in calculating which banks should be characterised in this way, as well as the problems involved in regulating banks which are already ingrained in the financial system, put considerable limitations on potential solutions to the overall problem. In the long term, it will be interesting to see how financial regulation is curated to chip away at the too-big-to-fail problem.