We are all familiar with the phrase “the bigger they are, the harder they fall.” Basically, the more powerful someone or something is, the more harmful their downfall will be should they lose that power. The same principle applies to finances, particularly with the phrase “too big to fail.” This phrase applies to contexts outside of economics, but it is especially prevalent in a financial sense.
What does it mean?
“Too big to fail” describes a business or business sector that is deep within a financial system or economy. In fact, their involvement is so deep that the business’ failure could spell disaster for the entire economy. For that reason, the government considers bailing out this business or potentially the entire sector to prevent economic disaster. Examples of such sectors can include U.S. carmakers or even Wall Street banks.
“Too big to fail” in terms of banking is regulators’ unwillingness to close a large bank that is in trouble. This reluctance stems from a belief that the short-term costs of a bank failure are too high.
The popularization of the colloquial term “too big to fail” is courtesy of U.S. Congressman, Stewart McKinney. Specifically, during a 1984 Congressional hearing discussing the Federal Deposit Insurance Corporation’s intervention with Continental Illinois. Prior to this, the term would see the occasional usage in the press, and similar thinking incentivized earlier bank bailouts. These earlier bank bailouts were largely thanks to concerns regarding the “too big to fail” issue.
After thousands of bank failures from the 1920s to the early 1930s, a change was clearly in order. In comes the creation of the Federal Deposit Insurance Corporation (FDIC). Their job is to monitor banks and insure customers’ deposits. Its launch gave many Americans confidence that their money would be in safe hands inside the bank. Today, the FDIC insures individual accounts in member banks for up to $250,000 with each depositor.
The 21st century would present entirely new challenges in bank regulations. This specific brand of regulating created both financial products and risk models that were unimaginable in the 30s. The exposure of these risks would be courtesy of the 2007-08 financial crisis.
The first failure
The title of the first “too big to fail” bank goes to Bear Stearns. Once a small yet very popular investment bank, Bear Stearns had a heavy investment in mortgage-centric securities. Upon the collapse of the mortgage securities market, the Federal Reserve gave JPMorgan Chase & Co. $30 billion. With this, they could purchase the Bear Stearns and relieve any concerns that confidence in other banks would turn sour.
Use during the 2008 Recession
While the coining of the term was in 1984, it was popularized in light of the Great Recession from 2007 to 2009. Former President George W. Bush’s administration revived “too big to fail” in light of the catastrophic financial event. The administration would use the phrase as a way to describe why it was bailing out several financial companies. Furthermore, its purpose was to avoid economic collapse on a worldwide scale.
The firms in need were all financial firms. They rely on derivatives to gain a competitive advantage in the booming economy. Upon the complete collapse of the housing market, their investments would have the potential to ruin them. These banks had a sizable investment in these derivatives. So much so that they would become ‘too big to fail’.
The Dodd-Frank Act
Many believe that the main cause of the Great Recession was financial firms taking on too much risk. Regulators saw that closer examination in the future would be important in the prevention of a repeat. They point out that numerous companies in this industry are deep in the economy’s overall functionality. Alternatively, as they put it, they are too big, complex, and analogous to fail.
Enter the 2010 Dodd-Frank Act, a response to the financial crisis. Courtesy of the Financial Stability Oversight Council (FSOC), Dodd-Frank helps avoid the need for any potential financial system bailouts. Among its abundant provisions were new regulations pertaining to capital requirements, consumer lending, and proprietary trading. Dodd-Frank also dictated higher requirements for banks with the systemically important financial institutions (SIFIs) label.
A SIFI is a specific type of bank, insurance, or other financial institution. It is one that U.S. federal regulators believe poses a serious risk to the economy in the event of its collapse. A SIFI is “too big to fail” and thus, it is imposed with extra regulatory restrictions. These effectively prevent them from going under. Nevertheless, a SIFI label will typically bring more scrutiny and additional rules and regulations.