Too Big to Fail Theory - Example

Too Big to Fail of the of the Contents Contents 2 Introduction 3 Describing the problem 3 Comparison of remedies 4Acts of Congress to address the problem 6 Conclusion 7 Introduction In simplest words, the “too big to fail” (TBTF) theory describes a situation, where the business of an organization has become so profound and infinite, that failure of the same will lead to spillover effects on other sectors of the economy. This will systematically weaken the economy. To prevent this from happening, it is firmly believed by economic agents that the government will intervene in the problem and provide the organization with any technical and financial support that it needs in order to avert the failure (Gup, 2004). This happens because if a large organization fails, then all smaller organizations, which depend on this major business, will tumble down as well, thereby weakening the entire economic system. The only option for the government is to compare the cost of such a disaster with a potential bailout for saving the economy. This paper describes the problem and discusses possible remedies, which have been gaining momentum in the academic and government circles. Attitude of the congress to solve the problem is also addressed to realize the efforts taken by the government in this regard. Describing the problem The problem mainly pertains to any massive institutions, but this study here focuses on financial institutions. The term “too big to fail” describes a situation for the bank regulators, when largest banks of the economy are in severe financial trouble. The situation leads to a condition, which makes banking regulators take actions to save the bank from bankruptcy. The size of externalities that can occur, in case of fallout, does not only depend on magnitude of the institution, but also on the particular mix of business activities and degree of interconnection with rest of the financial industry. The presence of this large negative externality is feared the most. The article published by New Republic magazine states that root cause of the problem is connectivity of the institutions with one another. They are systematically linked among themselves, which will cause a chain failure, if one of them goes bankrupt. Under such circumstances, regulators are not left with too many options, but only to prevent the collapse of financial institutions. The financial crisis in 2007 was the cumulative effect of bad bets in investment, irrational mortgage backed financial instruments and irresponsible rating agencies. The problem began to surface when massive financial institutions threatened to bring the economy down, unless they were helped by the government agencies. This forced the Washington government to spend billions of dollars for saving the largest commercial banks, like, Citigroup, AIG, Bear and JP Morgan, to name a few (Boone & Johnson, 2010). Zhou (2010) in his research work upholds financial interconnectivity between the institutions and in turn measures the systematic importance of financial institutions. The pertinent question, in this regard, is whether the size of an organization is an important determinant to decide if it should receive the bailout. The technical answer to this question is not very straightforward as the extent of adverse effects on the economy relies on contribution of the institution to the financial system (Zhou, 2010). The major downside of the bailout problem is that it distorts market discipline as preference is given to large financial institutions and this in turn aggravates their risk taking behavior, as they are complacent that the government will save them. This often leads to a moral hazard problem, allowing large firms to manipulate the government to save them, even if they behave irresponsibly (Wolgast, 2001). Though the government is fully aware about the moral hazard problems associated in bailing these institutions, yet the global financial crisis had witnessed the government doing the same. It has been observed that the most unfair bailouts during the crisis were not of the banks themselves, but of the bondholders. This is unjust because these investors were the ones to provide money for funding the bad decisions, which had culminated in the crisis. As a result, shareholders of these institutions had to bear losses, but the bondholders were protected by actions of the government to stabilize the economy (Swagel, 2013). The large banks were fully assured that they were covered by taxpayers, as the government will somehow provide for their losses. Comparison of remedies Since initiation of the TBTF problem and its aggravation, several economists, scholarly personalities and governments have come up with ways in which the problem can be reduced to an extent. The existing literature points out to the fact that there is no simple solution to this difficulty as the situation is too complex to solve by single solutions. This segment compares the remedies that have been proposed by various agencies. Firstly, the solution that has been proposed is to limit the size of the corporation, so that they cannot pose as risk of global failure. This ‘size’ can imply magnitude in terms of revenue, number of employees, market share or capital. This can be done by divesting assets and breaking them up to the point, so that they can no longer remain TBTF. This will limit power of the organization to manipulate the outcome in their favor. This remedy has been criticized by the fact that economies of scale in operations will be lost, if activities are constrained. Even so, determining exact size of the institutions can be a challenge (Wall, 2010). Secondly, reforming the corporate governance of large corporations can also provide a plausible way to reduce the problem to some extent. A report from OECD shows that the corporate managers are irresponsible in the context where they can bet with the public money. Constraining these actions will limit them and corporate greed can be tamed. However, forming the correct set of corporate governance, that would be accepted by all and sundry, is difficult. Thirdly, introducing corporate tax laws can also be an efficient way to reduce the financial power of corporations. This will also be beneficial to increase revenue of the government and make the whole economy better off. This solution also has an inherent problem because high corporate taxes drive business organizations out of the countries and enforcement of these laws also poses a threat for the economy (Bayern & Teachout, 2014). Finally, the most important way to coordinate all these actions is an austere regulation and supervision board, which should be able to monitor all speculative and investment activities of the bank. In fact, putting the previously mentioned activity in action can be quite a challenge, but regulation of firms may be feasible as well as an efficient method of controlling activities of massive financial institutions. With the advent of globalization, activities of financial institutions had become more complex. However, the regulatory authority was not very well organized, which was one of the biggest reasons of the systematic failure. According to the possible options that have been discussed in this limited study, the best possible remedy is increasing strictness of the regulations. This is because prudent regulatory method, which covers all major issues like, capital adequacy, speculative trading and responsible lending, can strengthen an institution from within, thereby helping the same to absorb unprecedented shocks in any future distress. Acts of Congress to address the problem The Congress has not been exactly ideal in dealing with the issue in hand and several actions have been taken by them in order to mitigate the crisis. The most significant actions are summarized below: Firstly, in order to deal with the problem of limiting the size of the bank, Section 121 of Dodd-Frank Act establishes that the Federal Reserve and Financial Stability Oversight Council will have full authority to prevent mergers and acquisitions, restrict products of firms and sell the assets if it exceeds the 50 billion dollars mark. The cap of the merger and acquisition has been fixed at 10%. This implies that no bank, coming through mergers and acquisitions, can hold more than 10% of nation’s bank deposits (Dudley, 2012). Secondly, regulatory supervision has been improved by establishment of the Financial Stability Oversight Council, which makes the effort to single out banks that can pose threat to the financial stability of the nation. The capital adequacy of banks has been raised, if it is identified as the one that is systematically important. Additionally, IOSCO has been set up to formulate the global standards to be followed as principles for the financial market infrastructure. The various measures that have been introduced include stricter evaluation of firms on a cross-industry basis, thereby helping to identify the best practices. The organizations, which are lagging behind in areas like, MIS, governance, model validation, and risk management practices, are constantly being upgraded to make the financial system more robust (Labonte, 2013). Thirdly, the government has undertaken stern steps, so that large and complex institutions are not able to become larger and more complex. To meet this end, an additional specification has been introduced in the Dodd-Frank Act, which eliminates the “risk to stability of the U.S. banking or financial system”. This will particularly act as an additional measure of evaluation in the proposed merger and acquisition. Fourthly, even on the liquidity front, there have been quite a number of developments, which will act to better the liquidity situation of financial institutions. For example, banks, which have been identified as systematically important, will be required to hold a 30 day liquidity buffer, known as the Liquidity Buffer Ratio. The objective here is that if a situation of financial distress arises in the future, then these institutions would be self-reliant to fund themselves against the fire sale externalities. Finally, a host of other actions are underway, which can reduce vulnerability of financial institutions, like, reformation of the OTC derivative market, which is expected to reduce the bilateral exposures between firms so as to reduce impact of systematic failing (Dudley, 2012). Conclusion This project discusses the “too big to fail” theory that has been gaining prominence, since aftermath of the recent global financial crisis. The first section of the essay describes the idea or significance of the term. The next section deals with possible remedies, which have been proposed for solving the problem. It has been realized that there appears to be no single solution that can become a panacea to these problems. Comparing the remedies, it seems that improving regulation by the government would be the most feasible way to control the TBTF problem. The final section of the paper discusses the steps, which have been taken by the Congress, to solve the crisis. After studying the governmental actions, it can be stated that the government is trying to clear the mess, but a long way lies ahead before the problem can be reduced, if not eliminated. References Bayern, S. & Teachout, Z. (2014). A New Way Forward – Restore The Economy In The Publics Interest. Page Lines. Retrieved from Boone, P. & Johnson, S. (2010). Way too big to fail. New Republic. Retrieved from Dudley, W. C. (2012). Solving the Too Big to Fail Problem. Federal Reserve Bank of New York. Retrieved from Gup, B. E. (2004).Too Big to Fail: Policies and Practices in Government Bailouts. Westport: Greenwood Publishing Group. Labonte, M. (2013). Systemically Important or “Too Big to Fail” Financial Institutions. Congressional Research Service. Retrieved from Swagel, P. (2013). Reducing the Impact of Too Big to Fail. New York Times. Retrieved from Wall, L. D., (2010). Too Big to Fail: No Simple Solutions. Federal Reserve Bank of Atlanta. Retrieved from < http://www.frbatlanta.org/cenfis/pubscf/vn_no_simple_solutions.cfm> Wolgast, M. (2001). Too big to fail: Effects on competition and implications for banking supervision. Journal of Financial Regulation and Compliance, 9(4). Retrieved from Zhou, C. (2010). Are Banks Too Big to Fail? Measuring Systemic Importance of Financial Institutions. International Journal of Central Banking, 6(4). Retrieved from Read More