“Too Big To Fail” is a theory that is defined as the incident wherein financial institutions become so large, connected and inter-dependent, that a failure of one of these institutions would result in economic failure. The theory thereby underscores the importance of government intervention whenever these financial institutions face difficulty. The term “Too Big to Fail” was first used in 1984 by United States Congressman Stewart McKinney. Congressman McKinney used the term to describe the intervention of the Federal Deposit Insurance Corporation, a US government financial agency, with the affairs of Continental Illinois. Continental Illinois was one of the largest banks in the United States which failed in the 1980s, necessitating a takeover by the Federal Deposit Insurance Corporation. Because of its size, the US government had to intervene through a cash infusion, reported to be about US$ 4.5 billion .
The theory is based on the belief that some institutions are so important, that their failure will result in more serious financial and economic problems for their countries. This belief is supported by some economic theories. For example, the economic scale of banks and other private institutions are big enough to be effective in implementing economic management policies. The impact of their effect is seen by some economists to be significant and therefore enough of a justification for government intervention to prevent any risk of collapses . Supporters of the theory liken it to sovereign states that are large enough such that any thought of their failure would be catastrophic to the global economy.
Critics of the theory say that government intervention for private company failures is morally hazardous. They state that a company that knows it will benefit from protective government policies will deliberately take risky positions. This critique of the “Too Big to Fail” theory was highlighted in the recent global financial crisis, wherein the US government had to bail-out financial institutions that were erroneously, if not maliciously managed. Critics add that continued proliferation of this approach will result in loss of productivity and economic efficiency. There is a very large group supporting the dissolution of this approach, saying that if an institution is too big to fail, that institution is just too big . Until today, this problem has not been dealt with, with finality .
The fundamental issue of the “Too Big to Fail” argument is due to the size, complexity and interconnectedness of banking institutions. A failure of one of these financial institutions will bring about a domino effect that cannot be ignored. US banks for example, have assets of about US$9,576 billion (as of 2012) or about 59% of the US Gross Domestic Product. Of all these banks, about 5 control approximately 30% of the total banking assets. Thus, one of these five failing would result in serious issues for the other four and ultimately the US economy. These banks are recipients of large deposits from individuals, a large economic component for investments and money management. About 10 US banks hold approximately 50% of all US deposits in 2011, thus bearing significant size and importance.
The United States Federal Government decided that best approach to managing the risks associated with size, complexity and interdependence is through stricter regulations. In 2010, the US government ratified the Dodd-Frank Act. This law was enacted to help strengthen the regulatory framework for financial services, through the creation of better risk-management metrics such as lower leverage ratios, higher capital asset ratios, retention of sellable assets, a ban on proprietary trading which uses customer deposits, and the prohibition of banks from entering into lines of businesses that were unrelated to their fundamental purpose. All of these measures are projected to provide adequate protection that would prevent another catastrophic financial meltdown.
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McKee, Michael and Scott Lanman. Greenspan Says U.S. Should Consider Breaking Up Large Banks. 2009. 17 May 2014 <http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aJ8HPmNUfchg>.
Washington Blog. Top Economists and Financial Experts Say We Must Break Up the Giant Banks. 2013. 17 May 2014 <http://www.ritholtz.com/blog/2013/03/top-economists-and-financial-experts-say-we-must-break-up-the-giant-banks/>.
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