Global economics “too big to fail” issue

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Table of Contents

Introduction
Proposed Solutions
Conclusion
Works Cited

Introduction

Writing for the American Prospect Magazine, Fernholz calls the “too big to fail” concept as the “most hated and least understood Orwellian phrase that usually arise during financial crises” (Fernholz 8). According to (Stern & Feldman 9) too big to fail is the believe that large financial corporations can not fail as the governments watches , since by doing so, the government would be letting the bank to drag down investors, employees and creditors of such institution.

Logic therefore dictates that any government that cares about the financial repercussions that such a fall would cause will always intervene to prevent the financial institution from closing shop.

Looking at recent trends, one gets the impression that size is not all that matters for a financial institution to be categorized as too big to fail. The systemic risk posed by a bank failure is also a major consideration. That explains why the government watched as Lehman brothers failed, while it moved in to prevent Bear Sterns from falling despite the fact that the former had a larger capital base (Fernholz 10).

The too big to fail problem was best described by Jurist Louis Brandeis when he wrote, “Size, we are told is not a crime, but size may at least become noxious through how it is attained or the uses to which it is put” (Dash 3). Aptly put, the too big to fail would not be a problem if too many financial institutions are not becoming bigger through mergers and diversification, and further, with the assurance that the government will not let them fail, goes ahead to take unwarranted risks which could jeopardize their operations.

Financial institutions have acquired the “too big to fail’ status with the full knowledge that with size comes some safety from the government and by the extension the taxpayer, because in the event of financial difficulties, the policy makers would fear the enormous effect that their collapse would cause to the economy. According to (Dash 3), too big to fail institutions nestles in the comfort of almost assured tax-payer financed bailouts.

But why is “too big to fail” a problem? According to (Stern & Feldman 9), the too big to fail concept elicit a feeling of unfairness especially in smaller institutions, which are justified to think that the government does not value their systemic importance as it does the interconnected big banks.

“When such banks feel that they are gauged differently and are not given the same competitive advantage, the temptation to pursue mergers for purposes of gaining the same leverage as the big financial institutions is always a possibility” (Stern & Feldman 9).

A broader concern is the “moral hazard” that occurs from the too big to fail concept. With increased reliance on government bailouts in the big financial institutions, the bank operators are more likely to be less disciplined in the management of the banks. Creditors on the other hand, may be less cautious when dealing with such banks, a trend that encourages excessive risk taking.

Closing an insolvent bank is usually met with disproval from people adversely affected by the move. To avoid this (Hetzel 8) reckons that regulators always postpone doing so, thus attracting political pressure to keep the bank afloat. However, it is not only political pressures that are responsible for postponement of closing of insolvent banks.

Due to the mere volume of business conducted in the too big to fail banks, the regulators may have a hard time determining whether a bank is indeed insolvent or not. This is because the bank’s assets as well as its market value may be hard for the regulators to grasp especially where proper books are not in place, or where the bank is reluctant to cooperate with the regulators (Hetzel 8)

The failure of a banks and other financial institutions is something that financial analysts believes happens due to taking up risks, lack of proper planning or just unpredictable market rates especially in the lending sectors (Wallison 13; Stern & Feldman 3).

While some banks fail without much notice being taken, others capture the attention of policymakers especially due to their sizes and their role in the financial market. The policymakers react by giving banks discretionary financial support, which shields uninsured bank creditors from the loss they would otherwise face if the bank were allowed to fail.

Financial analysts agree that the too big to fail concept hurts the free market economy. They however differ about the most viable method to handle the problem. Comparing the AIG bailout and the collapse of Lehman Brothers, in 2007-2008-2009 recession that hit the world economy, (Wallison 13) argues that “letting financial institutions to fail may be the best solution after all, Lehman Brothers’ failure did not have substantial losses.

Within weeks of filing for bankruptcy, the bank’s trustee had sold its investing banking, investment management and brokerage businesses, thus recovering a substantial amount of their asset base.” In contrast to Lehman, AIG received government bailout but continued wasting away even under the government’s watch, thus putting the wisdom or usefulness of the bailout into question.

Watching the markets in the wake of the Financial crises that hit the markets between 2007 and 2009, it’s notable that some financial acquisitions that were necessitated by the need to save some institutions from falling further complicated the too big to fail issue.

Wells Fargo increased its assets base by 43 percent after buying Wachovia, JP Morgan Chase bought Washington Mutual and Bear Sterns consequently increasing its asset base by 51 percent, while Bank of America’s asset base grew by 138 percent after acquiring Merrill Lynch and Countrywide (Fernholz 10).

According to (Cho 1), the recent trend is worrying because not only does the US economy has banks that are too big to fail, but those banks are growing bigger, thus posing an even bigger systemic risk to the economy.

Accordingly, this may lead to a situation where consumers only have very few financial and banking choices, and the big banks could adopt even riskier behavior due to the presumption that the government will back them when they face financial difficulties. Cho (2) reckons that these acquisitions by the banks that were considered stable were arranged by government and regulation procedures such as applicable bank-deposit share ignored in the process.

Proposed Solutions

Regulation

More strict regulation for the banks is among the most touted means of ensuring that the banks stay within manageable levels. According to Fernholz (9) size has got nothing to do with the systemic risks that these “too big to fail” institutions pose on economies. “Rather, it is the lack of a uniform way of letting such banks fail gracefully that poses a greater problem” (Arthur Levitt quoted by Fernholz 9).

Strict regulations will mean that the banks will be forced to adhere to some codes, which will in turn force them to put safety nets in place. Further, regulation will help banks and financial institutions that encounter grave financial difficulties to “fail gracefully”

Stern & Feldman (11) argue that for banks to be allowed to fail, the creditors of such banks must first be informed by the policymakers and the government that they indeed face incredible loss’ risks. This argument is based on the conviction of these two authors that governments bail out big banks, not so much because the banks would cause a ripple effect in the economy, but because creditors of such banks have come to rely on government’s explicit shield of protection.

Overall, more strict regulations would encourage stricter capital, compensation, liquidity and risk management by forcing the institutions to set incentives that would encourage careful risk taking. According to (Roubini 2) banks can even be forced to pay insurance premiums, which would help guard them against systemic risks in future.

Stricter regulations would also mean that regulators get to crack down on firms that engage in risky dealings before they are fully immersed into the same thus saving creditors from exposure from resulting risks. This is the most potent solution to the too big to fail problem, yet, it is highly unlikely that regulators would be able to enforce the necessary regulations “without protecting poor performers, stifling innovation, and leaving regulation loopholes that could only worsen the financial situation” (Francis et al 2).

Bring them down to Size

The proponents of resizing the too big to fail institutions argue that this is the only way that regulators can be able to oversee the operations of such in order to ensure that they stick within their mandated zones. “Such institutions should be broken up and the unsecured creditors given an automatic claim in to the institutions’ equity” (Roubini 1).

Other financial analysts recommend that the interconnectedness that makes the financial institutions too complex should be broken. “Investment banking poses increased risk to most such institutions, and hence should be separated with commercial banking and insurance” (Roubini 1).

There is also a school of thought that proposes that the too big to fail institutions should be allowed to plan for their own demise in an orderly manner. In such a proposition, “the institutions would prepare how well to unwind their derivatives, settle estates and move assets depending on the perceived risk of failure” (Francis et al 2). This argument is based on the assumption that the too big to fail companies would know the most ideal way to break up the interconnectedness that has resulted in them posing systemic risks in the economy.

Most viable solution (opinion)

This paper acknowledges that there is no simple solution to the too big to fail problem. However seeing that leaving them as they are now will only continue posing more risks to the bigger economy in future, it is only wise that solutions to the same be found sooner.

Considering the proposed solutions above, this paper is of the opinion that regulation is the most ideal way of handling the too big to fail problem. “The truth about size is that expansion and diversification is the bedrock of the American enterprise. In the financial sector, the genie of diversification is already out of the bottle. As such, all solutions should forget the probability of ever containing the genie in the same bottle again” (Wallison A13).

I also support regulation because resizing banks may seem like a good solution on paper, but may be quite difficult to implement. Statistics indicate that the four largest US banks hold more than 40% of deposits in the country and more than 50% of all assets. With this in mind, it is apparent that even if the resizing was to be done, it would pose myriads of logistic challenges.

More to this, it would take years for resizing to be attained. Breaking the institutions does not look like a viable option to me because, the banks that have grown over the years to acquire the “too big to fail” status, have done so gradual planning and risk taking. As such, it is quite evident that their growth path was neither accidental nor instant; rather, it was gradual and organic like many other enterprises in a free market economy.

Conclusion

The policy makers will need to take action regarding the Too big to fail concept sooner or later. This is especially so if the economy is to be shielded from more systemic risks from such behemoths. No one solution promises an easy way of handling the situation.

As such, as they will have to devise ways through which people can learn to live with the banks without being exposed to the risks as is the case today, or they will need to put target limits into extents to growth of financial institutions. Whatever the case, regulation should be adopted to allow banks enough room to prosper and grow, but they should be allowed to fall when market forces demand so.

Works Cited

Cho, D. “Banks ‘too big to fail’ have grown even bigger: Behemoths born of the Bailout reduce Consumer Choice, tempt Corporate Moral hazard.” Washington Post. 2009. Web.

Dash, E. “If it’s Too Big to Fail, Is it Too Big to Exist?” The New York Times. June, 2009. Web.

Fernholz, T. “The Myth of Too Big to Fail: When it comes to banking, size isn’t the only Thing that Matters.” The American Prospect Magazine. 2009. Web.

Francis, T., Henry, D. and Goldstein, M. “Too Big to Fail Still an Issue: Unless government leaders figure out a way to shrink global finance giants to manageable sizes, taxpayers will surely foot the bill to more bailouts.” BusinessWeek. 2009. Web.

Hetzel, Robert, L. “Too Big to Fail. Origins, Consequences, and Outlook.” Economic Review.Vol 20 (2). 1991.

Roubini, N. “Too Big to Fail Revisited: Regulatory reforms of systemically important institutions.” Forbes. 2009. Web.

Stern, G. & Feldman, R. Too Big to Fail: The Hazards of Bank Bailouts. Ed. New York: Brookings Institutional Press, 2004. Print

Wallison, Peter, J. “Too Big to fail, or Succeed: Everyone will want to become big enough to enjoy ‘systemic risk’ protection.” The Wall Street Journal. 2009. Web.

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