Too Big to Fail Essay
Too Big to Fail
The term ‘too big to fail’ is the idea that a business has become so large and generally does business with many companies for suppliers and services. The company will ingrain in the economy and others company will rely on it for portions of income. If it facing financial problem may cause of failure, the government will provide assistance to prevent its failure. Therefore, if the cost of a bailout is less than the cost of the failure to the economy, a government may decide that a bailout is the most cost-effective solution. Too big to fail” describes the belief that if an enormous company fails, it will have a disastrous ripple effect throughout the economy. (Unknown, 2013) (Amadeo) There is a general consensus amongst regulators that the too big to fail banks have gotten ‘too big to jail’. The sizes of the banks have become so systemically important that it is a national risk if government has allowed it to fall. US Attorney General Eric Holder admitted that the big size financial institutions have created complexity of their structures.
The U. S. Department of Justice (DOJ) has given up on trying charging the bankers and operators of these financial institutions in matters of corruption or criminal malfeasance. The reason given by them is that if they bringing down any of these huge banks or businesses, it could cause crash the economy. For example, according to the senior U. S. Senator, Elizabeth Warren that even though the bank HSBC had admitted to laundering over 800 million dollars for drug cartels, but they paid the largest fine in history of $1. billion in relation to money launder instead of the banker being charged and jailed. From the action of DOJ, it seems that the only way to punish or the authorities can enforce is just the giving out fines as speeding tickets.
However, even speeding tickets will result in demerit points and loss of license. But, since the mega banks are pointed as too big to fail and if their operating licenses being revoke, the government believe the country or world economy may affect significantly. (Chan, 2013) (Puzzanghera, 2013) According to U. S. Federal Reserve Chairman, Ben Bernanke, said, ‘too big to fail is the major source of the crisis and we will not have successfully responded to the crisis if we do not address that successfully’. From my point of view, the term ‘too big to fail’ does adequately explain why many financial institutions continue to encourage risk-taking activities by their executives. The formal history of ‘too big to fail’ begins with the failure and subsequent bail out of nation’s seventh-largest bank, Continental Illinois National Bank and Trust Company (CINB) in the year 1984.
CINB forced regulators to recognize not only those very large institutions could fail but also that bank regulators needed to find satisfactory ways to cope with such failures. In September 1984, The Comptroller of Currency testified before the US Congress that some banks were simply “too-big-to-fail” and for those banks’ deposits will be covered under full deposits guarantees, thus marking the formal acceptance of a ‘too big to fail’ policy. [ (Chan, 2013) ] [ (Puliyakot, 2011) ] [ (Unknown, The History of Too Big To Fail, 2011) ]
Starting from 2007, the term ‘too big to fail’ had been familiar in the world to describe why the government needed to bailout some companies. This is because of the U. S’s subprime loan crisis and Europe financial crisis. During financial crisis, it been found that many firms especially those who involve in financial industry or financial institutions asking for the help of government and there are some being bailout but unfortunately also forgo by their government. In U. S, the government bailouts out company like Bear Sterns, AIG, Citibank and etc but it also let the Lehman Brothers to fail. These banks and insurers are well known as the financial institutions use to improve their profitability by creating, then selling, complicated derivatives. They also traded risky loans, commodities, currencies and stocks because they know if their investments going south, the taxpayers would be forced to bail them out. [ (Amadeo) ] [ (Helwege, 2009) ] But, how big is too big to fail? And how would the government measure it anyway?
In the case of bank, Lehman Brothers was known as too big to fail. And from the result or consequence of the failure of Lehman Brothers, it can clearly observe that when Treasury Secretary Hank Paulson refuse to bailout, the financial market being affected and the impact of the failure cause the Dow dropped nearly 350 points and spreading of panic widely. While, in case of AIG, one of the world’s largest insurers, AIG’s credit default swap (CDS) cause it almost to fail because AIG was unable to cover the swaps.
But, the Federal Reserve provided an $85billion of two-year loan to AIG to prevent it from bankruptcy and further stress on the global economy. In U. S financial crisis, Lehman Brothers became the only too big to fail firm never bailout by the government. And, the consequence had warned the government that the collapse of one big financial company could cascade through the industry. Since then, the big companies with financial problem always receive the help of the government. And, this could also explain why ‘too big to fail’ is not over. Unknown, The History of Too Big To Fail, 2011) (Amadeo) Next, the using of depositing insurance by banks in many of the countries since the great depression also had been issue and question by the regulator which that it was found that using this deposit insurance not only allow the banks to run the business unquestionable and also bring along with the problem of potential for moral hazard risk taking by the banks. The bank action of taking risky activities has left many wondering whether the net effect of a deposit insurance scheme is positive and warranting its continuation.
The main source of incentives for risk taking by banks under deposit insurance is the implicit subsidy provided by the deposit guarantee scheme as well as the option value of a fixed premium deposit guarantee. Another source of incentive for risk taking under fixed price deposit guarantee is the option value of fixed price deposit insurance. By issuing a guarantee, the guarantor has promised to repay the full value of the debts of the bank to its depositors and creditors in exchange for the value of the bank’s assets.
It is easy to see that the value of this option is maximized when the value of the bank’s assets are the lowest. Too big to fail policies imply a full guarantee on the banks deposits at a fixed cost of zero, thereby magnifying the above incentives of the equity holders. [ (Merton, 1977) ] [ (Puliyakot, 2011) ] For the bankers and insurers, they are using others people money to run their business and the existing of government had become a guarantee for them.
Promise of too big to fail bailout and continue subsidizing strategy has changed the mind of the depositors and unsecured creditors, as well as the equity shareholders simultaneously. For depositors, unsecured creditors and especially the operators of financial institutions, the promise from government of too big to fail bailout is just like a sponsored safety net because it is giving a full or unlimited guarantee on them of their investments and deposits. But, there is a large body of literature which proves that fixed premium of full deposit insurance leads to increased bank risk taking.
The implicit of deposit insurance and fixed premium insurance contract are the commonly cited reasons for increased bank risk taking. The banks or financial institutions are working with the objective of their shareholders’ wealth maximization instead of their depositors. They will achieve their goal by increasing the asset risk and minimizing the capital, thus extracting the maximum value out of depositors. However, the depositors are indifference to the action of the financial institutions because they believe their deposits are protected by the too big to fail policies.
This showed that the behavior of depositors either explicit or implicit provide financial institutions moral hazard incentives for excessive risk taking. [ (Puliyakot, 2011) ] Thus, this has become the reasons which encourage them to continue to involve in risky activities. Despite of that, they want to involve in risky activities also due to their characteristic of capitalism and greedy. This is because risky activities can make higher return and maximize their wealth instead of benefit the public investors. However, even though they like to take risk but they will never intend to get hurt from risk.
Hence, they make the government as a shield to protect them only because government and taxpayers have to bear for their mistakes and paying their debt. And, it create a vicious cycle if ‘too big to fail’ policy never stop. According to Penn State’s Smeal College of Business, the U. S. economy would be better served by letting failing firms file for bankruptcy rather than by bailing them out under presumptive federal policies that deem them to be ‘too big to fail’. [ (Young, 2012) ] [ (Helwege, 2009) ] The same thing also happens in Europe.
And for Europe, the biggest issues in resolving the financial crisis is that the European Central Bank (ECB) has to oversees 17 independent banking systems in its member countries who all sharing the same currency. According to Angelo Young 2012, the key to stabilizing the financial market is that the banks need to sell their risky assets at depressed prices or even at losses and this basically is ask them to go back to their to their roots as smaller size in order to reduce threats to the global financial system from too big to fail syndrome of euro zone banks.
However, some of the Europe’s largest banks seem to not keeping up with their end of a deal to reduce their too big to fail problems. This is because ECB was decided to provide them a loan of €489 billion in December and another loan of €530 billion. After the ECB announce its decision, the banks have resulted in grown up with increased their assets instead of getting smaller. They have gotten comfortable enough with their dependence on the ECB. (Young, 2012) According to Simon Maughan, bank analyst for Olivetree Securities Ltd. in London, he told the Bloomberg News that instead of deleveraging, the banks are leveraging.
The reason is that the euro zone bankers still need another round of ECB’s bailout in order to settle their financial problem hence they will go leveraging again. In fact, with the expect of another bailout from ECB again, the banks have not been try to sell their risky assets to reduce their debt and cover the loss but the existing of ECB has make them to continue to invest in risky investment. Also, at the same time, the governments in most troubles euro zone economies such as Greece, Spain, Italy, and etc have been resulted that they are hesitant in letting their local bank to fail.
These local banks are considers as small bank if compare global banks and it is too big to fail only in their own country or locally but do not regionally affect to another country unlike the global financial institution like AIG and Citigroup. (Young, 2012) From the case happen and mentioned above, it clearly showed that too big to fail is becoming an encourage for financial institutions to continue taking risk is because banks and financial institutions which are deemed to be too big to fail are often bailed out and allowed to continue operations while they recover their losses, due to certain regulatory motivations.
Such bailouts, while effectively protecting the shareholders and managements along with the creditors, it also becomes an incentive of owners and management for increased in risk taking activities. Hence, bailout policies, which allow continuation of the bailed out entity as a going concern, can be expected to enhance the risk taking incentives of institutions which are deemed to be too big to fail. (Young, 2012) Besides, there is also a widespread perception among the investors and operators of financial markets, especially for those in the developed countries.
They believe that in case if a large bank or financial institution gets into financial problems, the government would in all likelihood to intervene in order to prevent its failure so that the losses of depositors and uninsured creditors will be limited. The regulatory motivation to bailout the creditors of a large bank or financial institution are to reduce the chances that will lead other banks to fail or capital markets to stop working efficiently.
At times, the troubled institution could be too large such that it is impossible to orderly liquidate it for want of ready markets for its assets, and also it is impossible to find an acquirer to acquire such a large institution with huge debt. Hence, regulators can only forced to continue such troubled institutions through unlimited liquidity support, regulatory forbearance, public capital infusions and subsidize their losses through their own operations. This possibility of a government bailout of a large bank or financial institution is commonly referred to as the ‘too big to fail’ policy.
While there was proven that government bailouts is an effective tool to avoid large financial institutions to fail or systemic collapse, but it also comes with its own costs in result. The expectation of contingent bailouts tends to create efficiency costs in the economy. In general, banks tend to become larger and riskier if its operators and creditors believe that they will benefit from too big to fail coverage. [ (Stern, H. G. & Feldman, J. R. , 2009) ] Regarding to Richard W.
Fisher and Harvey Rosenblum’s ‘How to Shrink the ‘Too-Big-to-Fail Banks’: Downsizing the mega size financial institutions would not only reduce systemic risks but it also help to level the regulatory playing field, and it would makes good business sense for much of the nation. While the megabanks’ too big to fail status provides them with implicit government backing and a soft touch from the Department of Justice (DOJ), it also means to stricter regulations for the entire banking industry. Congress has made strides toward distinguishing megabanks from community banks in its regulations and this is consider as risky practices on Wall Street.
It means resources that could be devoted to small-business growth and local development are instead directed toward meeting regulatory mandates. A restructure of these financial institutions is ask by the Federal Reserve Bank of Dallas President and CEO, Richard Fisher in order to help to restore market discipline, reduce taxpayer risk, and it will also provide for appropriate financial regulation and stronger economic growth in communities across the nation. (Emily Stephenson and David Henry, 2013) (Staddon, 2013) Unfortunately, it is not easy to be practice successfully.
According to president of Federal Reserve Bank of Richmond, Jeffrey M. Lacker said that the ending of ‘too big to fail’ is going to be hard work. The reasons he provided in his speech were the ending of the treatment of certain firms as ‘too big to fail’ requires addressing two mutually reinforcing issues. First, the creditors of these mega firms are protected by the implicit government support and the creditors’ problem need to be solve if these financial institutions are allow to fail. And second, there are still many policymakers are supporting certain institutions to protect creditors from losses. [ (Lacker, 2013) ]
In conclusion, the term ‘too big to fail’ does adequately explain why many financial institutions continue to encourage risk-taking activities by their executives. The financial institutions can continue to taking risky activities because they treat the ‘too big to fail’ policies as the shield to gain protection from government and taxpayers and can always bailout by them. While, depositors and creditors are convince by the promise of return on their deposit so that moral hazard is created and receive implicit subsidy from investors to subsidizing them and allow them to take high risk activities with unquestionable.
University/College: University of Chicago
Type of paper: Thesis/Dissertation Chapter
Date: 25 October 2016
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