The Complicated Reality of 'Too Big to Fail'

The Complicated Reality of 'Too Big to Fail'

"Too big to fail" continues to generate headlines five years after the start of the financial crisis. The scarlet letters of TBTF overshadow any positive news for the big banks. But do we know really the full story?

The basic intuition is straightforward: When an institution is considered "too big to fail" -- when everyone expects the government to bail it out in the event of a crisis -- it is able to borrow at an effectively subsidized rate, assume more risk, and operate with a level of impunity. Yet this intuition belies a much more complicated reality, as I explain in a new paper.

First of all, the popular narrative of bailouts being reserved for banks that are "too big" is not entirely true. The history of the federal government rescuing failing firms includes a mixture of large firms, not so large firms, banks, and nonbanks.

Continental Illinois, bailed out in the 1980s, was indeed large -- the eighth-largest commercial bank in the country at the time -- when regulators began to worry about foreign depositors fleeing. As part of the bailout, the FDIC decided to disregard its deposit-guarantee limits and back all the bank's deposits regardless of amount. But in doing so, the FDIC was exercising an authority that it had actually turned to more than once prior, for much smaller institutions.

The savings-and-loans in the 1980s were not individually so large, but their erstwhile deposit insurer nonetheless ran into trouble and needed public rescue. Years later, Long Term Capital Management (not a bank, and not particularly large) also received extraordinary support when its foreign currency bets went south. During the recent financial crisis, regulators used the Troubled Asset Relief Program to provide financial assistance to banks, large and small, as well as domestic automakers GM and Chrysler. Were the automakers large? Most definitely, but they don't fit nicely in the TBTF bank story. Regulators also stepped in to bail out Fannie Mae and Freddie Mac, two of the largest recipients of government support from the crisis.

What we see is not a straightforward pattern of banks consistently receiving assistance in times of distress by virtue of their size. It is much more an unpredictable pattern of ad hoc interventions toward institutions of various types and sizes, resulting from different solvency pressures. Moreover, the interventions are intermittent, and not always forthcoming -- in fact, given the history of financial-institution failures, they're fairly rare.

This is not to say bailouts are not costly or consequential, only that expectations of a rescue are beset by uncertainty. This is evident in the varying mechanism of each rescue: direct capital infusions, guarantees or backstops, equity stakes, favorable loans, etc., all complicate the relationship between bailouts and effective subsidies. It does bespeak the predictable outcome of the one through-line: excessive policymaker discretion.

Much of the recent research on the TBTF subsidy tends to look at the "cost of funds" for so-called TBTF and non-TBTF institutions -- that is, the interest rates these firms must pay to gain access to deposits and other funding. But besides having to demarcate two categories of institutions where a bright line doesn't exist, this work is made difficult by the reality that any number of factors affect these differences. Corporate bonds for larger firms tend to have lower yields across industries. This may be for several reasons, including liquidity, historical performance, and information advantages. Moreover, the funding differential between firms labeled TBTF and those not so labeled is always changing, during some periods even becoming negative.

Even if TBTF expectations don't increase consistently, it's possible they are increasing -- albeit unpredictably -- over time. Yet this raises the question of how creditors, depositors, and counterparties identify with any certainty which institutions are likely to be singled out at all. To wit, recent evidence suggests that insofar as the market prices in a bailout, it does so in a way that implies a sector-wide bailout and not one benefiting particular firms.

It's also important to remember that when it comes to TBTF expectations, the relevant beliefs are those of an institution's creditors. At a conference last year, the president of the Federal Reserve Bank of Minneapolis emphasized "the role of creditor beliefs about prospective governmental transfers," adding "the beliefs of other parties are much less relevant."

So far, the cumulative effect of years of policymaker discretion toward the financial system and the major regulatory reform embodied in the Dodd-Frank Act is indeterminate. Forthcoming studies on the TBTF subsidy from the International Monetary Fund and the U.S. Government Accountability Office will add to a growing body of literature on the subject.

Policymakers rightly worry about the pernicious effects of a system whereby some firms benefit from size, complexity, or other factors, at the expense of others, and ultimately put at risk taxpayers and the economy. But we shouldn't confuse a simple intuition with a complicated empirical reality. And until we more fully grasp the issue, regulators should proceed cautiously.

Satya Thallam is director of financial-services policy at American Action Forum.

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