Finance Theory – Too Big to Fail

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Introduction

The too-big-to-fail problem refers to the possibility of large financial institutions affecting a country’s financial system and economy owing to their financial failure (Davidoff par2). To prevent adverse effects on the financial system, the government assists large institutions whenever they face financial constraints.

Institutions that have large asset bases and whose financial activities play key roles in a nation’s economy experience this problem (Dudley par5). The problem arouses heated debates among financial experts and economists. Proponents argue that certain institutions are so important to a nation’s economy that the governmthe ent should implement protective measures to prevent their failure (Davidoff par4).

On the other hand, opponents argue that the problem presents a moral hazard because institutions that are core to the economy tend to take advantage and invest in high-risk financial transactions. Governments usually create protective measures that prevent the downfall of such institutions.

Analysis of the problem

Certain financial institutions like big banks play key roles in the financial systems of many nations. Therefore, their well-being determines the stability and well-being of the economy (Davidoff par3). If these institutions fail, then they disrupt the economy and the financial system of the country. For example, the downfall of Lehman Brothers disrupted the financial system of the United States.

The largest banks in the U.S own assets that are equal to 50 percent of the country’s GDP (Dudley par9). Therefore, the government takes the responsibility of improving their financial statuses when they face problems that could trigger their collapse.

Solutions to the too-big-to-fail problem

The problem can be solved in many ways including dissolving large institutions and forming smaller financial firms, heightening monitoring, increasing government regulating in order to reduce risk, and imposing risk taxes for large financial institutions.

Dissolution of large banks

Breaking up large institutions is controversial because the outcomes are not predictable. However, it can solve the problem. Many financial experts, economists, and financial analysts have proposed the dissolution of large banks and the consequent creation of small banks that are negligible with regard to their effect on the economy in case they collapse (Dudley par3).

The benefits of dissolving large banks include reducing the risk they pose to the country’s economy and eliminating their political influence that shapes the country’s policies. In the United States and the United Kingdom, large banks consume large amounts of taxpayers’ money through governments’ efforts to bail them out during harsh financial times (Davidoff par5).

In 2009, 106 banks went bankrupt in the U.S. alone because the government could not intervene due to their insignificant influence on the country’s economy. On the other hand, economists and financial experts argue that banks that are too big to fail should not exist because the risk they pose to the economy and financial system of a country overshadow their economic benefits (Dudley par4).

They argue that such institutions should exist only through government regulation. On the other hand, the dependency of big financial institutions on each other is one of the factors that cause the problem. Large financial institutions should be broken down into small institutions in order to solve the problem.

Increased government regulation

The government should pass legislation in order to increase regulation of the country’s financial system. In the past, Congress has passed several laws in an effort to regulate the financial system. For instance, the Dodd-Frank Act was enacted to increase government regulation. According to the act, banks are required to maintain large quantities of capital and solid assets that could be used to bail them out of severe financial situations.

The act was passed after the subprime mortgage crisis of 2007 that affected the economy severely (Davidoff par8). The crisis was so severe that it triggered the economic recession between 2007 and 2009. After the crisis, the government increased regulation of the financial system by reducing the leverage ratios of banks.

For instance, increased government regulation lowered the leverage ratio of Goldman Sachs investment bank from 25.2 to 11.4 (Davidoff par10). This ratio represents a low financial risk. The Dodd-Frank Act included a proposal to prevent banks from using their customers’ money to invest in risky investments for their own benefit. This practice increases the risk of a bank’s failure during moments of financial stress.

The act does not provide complete regulation because it allows proprietary trading in certain circumstances. Such loopholes render the act ineffective because banks find ways to circumvent financial legislation (Dudley par6). Another act that regulated banks was the Glass-Steagall Act of 1933.

However, the act was repealed in 1999. This allowed banks to engage in businesses that were not related to finance. Bringing back the Glass-Steagall Act would play an important role in increasing regulation of financial institutions and help to solve the too-big-to-fail problem.

Introducing risk taxes for large institutions

Another solution that could solve the problem would involve imposing taxes on large institutions to cater for the cost of the risk they pose. Taxing large financial institutions because of the risk they pose could encourage responsible and ethical financial transactions (Shamim par4).

For instance, the government could require such institutions to have capital bases that match their sizes in terms of their balance sheets and economic value (Hiltzik par4). Such regulatory measures would end impunity and protect financial institutions from political interference. If such regulations were implemented, it would be necessary to distinguish them from other mandatory regulations that aim to lower the risk of financial failure (Shamim par7).

Heightened monitoring

In 2011, the Financial Stability Board named 29 banks that were classified as too big to fail (Hiltzik par5). Among the 29, eight were located in the U.S. Many large banks in the U.S are interconnected with regard to their financial activities. It is necessary for the government to increase monitoring of these banks in order to determine how their failure could affect the economy and find alternative ways to reduce the risk.

For example, collateral management activities connect large banks. The government could solve this problem by offering better services that reduce the dependency of banks on each other (Dudley par5). It is also important for the government to find ways to dissolve bankrupt banks without affecting the country’s economy. The United State’s financial system favors too-big-to-fail institutions at the expense of small financial institutions.

Reducing the amount of funding that these institutions enjoy could solve the problem to a small degree. The funding advantage enjoyed by large firms encourages them to expand their activities thus increasing the risk of failure and the consequent effect on the economy (Hiltzik par6). The government should devise ways to prevent the collapse of large firms from affecting the country’s financial system.

Too-big-to-fail firms pose risks to the country’s financial system because they take advantage of the government’s funding to venture into risky businesses that affect their financial stability (Hiltzik par6). The government should first reduce funding and second, let such institutions collapse instead of funding them in order to stabilize them.

The fact that the government is ready to bail out such firms when they are at risk of collapse is a good enough reason for them to engage in risky financial activities that risk their financial stability.

Heightened monitoring of these firms would increase the transparency of financial transactions, improve the adaptation of such firms to an ever-changing financial environment, and facilitate the establishment of capital limits based on the risk posed by each institution (Other-Rone par6). Finally, it would develop effective resolution measures of collapse cases and thus reduce risk on the country’s economy.

Comparison of possible remedies

The aforementioned remedies would be effective in varying degrees. Dissolving banks would be effective. However, economists and financial experts are unable to predict the effects of breaking up large financial institutions and replacing them with smaller institutions. Imposing risk taxes on large institutions would not be as effective as increasing government regulation.

Introducing risk taxes would introduce unfair financial regulations because the taxes would only apply to large firms (Hiltzik par7). In addition, taxies would discourage lending. Increased monitoring would not be as effective as the other remedies because large firms would develop methods to conceal their transactions from government monitoring. The best remedy to the problem would be to regulate the financial system.

Recent acts that aimed to regulate the financial system have brought partial improvements (Other-Rone par7). Congress should pass more acts to regulate the financial system and ensure that firms do not expand to sizes that risk the well-being of the economy.

Current efforts by Congress to solve the problem

Congress has passed many laws that offer solutions to the problem. As mentioned earlier, Congress passed the Dodd-Frank Act that regulates the activities of financial institutions. The act contains the Bank Holding Company Act and the Bank Merger Act that regulate the size of financial institutions (Otker-Rone par8).

It is possible to minimize the effects of the failure of financial institutions by using the Title II liquidation process as provided in the Dodd-Frank Act. Despite the enactment of the act, the government declined to break up large banks. The Obama administration said that the economy needed them for stability (Davidoff par3).

In 2010, Congress introduced more financial reforms by passing the Consumer Protection Act and the Dodd-Frank Wall Street Reform. However, the reforms have been inefficient in regulating banks and other financial institutions that are too-big-to-fail.

Conclusion

The too big to fail problem presents many financial challenges to the government because of the interconnectedness of large financial institutions to the country’s economy. Possible solutions to the problem include imposing taxes to cater for the risk posed by large institutions, heightening monitoring, increasing government regulation, and breaking up large institutions into small firms.

The best remedy would be to increase government regulation. Recent efforts by Congress to solve the problem through the Dodd-Frank Cat and the Consumer Protection Act have been effective to a small degree. It is necessary to enact legislation that regulates the size of financial institutions.

The capital and assets of large financial institutions should match their sizes and economic values. Obama declined to break up large banks by claiming that the economy of the United States needed such big financial institutions for stability.

Works Cited

Davidoff, Steven. The Too Big to Fail Quandary. 2011.

Dudley, William. Ending Too Big to Fail. 2013.

Hiltzik, Michael. Addressing the “Too Big to Fail” Problem. 2009. Web.

Otker-Rone, Inci. Addressing the Too-Big-to-Fail Problem Before the Banks Become Too-Big-to-Save. 2011.

Shamim, Adam. Tax Banks to Shrink Too-big-To-Fail Lenders: Cutting Research. 2013. Web.

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