Too Big To Fail - Concepetual Disputation with Leopold Kohr

Diploma Thesis, 2011

93 Pages, Grade: 1






4.2.1 Originate and distribute model – Credit Securitization (Mortgage-backed securities, Collateralized debt obligations and Credit default swaps)
4.2.2 Rating agencies
4.2.3 Short-term financing

5.3.1 Bear Sterns
5.3.2 Lehman Brothers
5.3.3 AIG


7.2.1 Counterparty contagion
7.2.2 Information contagion

8.2.1 Moral Hazard and Creditors
8.2.2 Moral Hazard and Shareholders
8.2.3 Moral Hazard and financial firms executives
8.2.4 Moral Hazard and private investors







For when one asks, “What should have to be done with the large and complex financial institutions?” the reply is, “Too late, we have already done. They all failed. They are dead and we made them zombies.”

The global economy is experiencing the worst financial crisis since the Great Depression. During the financial crisis that started in the mid-2007 it became apparent what the deficiencies of modern global financial system are. Weak market discipline is not able to curb risk-taking. The misallocated resources create bubbles and inflation of asset prices. The financial system is dominated by too-big-to-fail institutions (TBTF) and regulators do not have capacity to control efficiently and properly resolve them. These institutions are complex and interconnected and regulators can hardly measure systemic risk impact of their operations. They are undercapitalized and rely on short-term funding of their operations, and use high leverage, what make them extremely sensitive to liquidity shocks.

As a result of the financial crisis the economic condition is weak, characterized by uncertainty and lack of confidence. The response of regulators has been to expand and extend access of large and systematically important financial institutions to explicit or implicit government-provided or sponsored safety nets, including explicit deposit insurance and implicit government guarantees, such as TBTF, that may protect de jure uninsured depositors and other institution stakeholders against some or all of the loss (Kaufman and Seelig 2001).

The term TBTF is applied especially in finance sector to describe how bank regulators may deal with severely financially troubled large banks (Kaufman 2003). When dealing with resolution of large financial institutions regulators usually find appropriate to prevent its failure by means of state support. Thus, the term refers to the practice followed by bank regulators of protecting large financial institution creditors from loss in the event of failure (Hetzel 1991).

Characterized as being “too big to fail” are very large or systemically important institutions, whose failure cannot be tolerated. Although the systemic relevance of an institution tends to increase with its size, the exceptional size is not the only indicator of systemic relevance. Interconnectedness and the extent of substitutability of company’s services are also criterion of systemic importance (Ennis and Malek 2005). It means that these institutions perform an essential activity in the smooth functioning of financial markets and payment system. Therefore regulators assist TBTF institutions in trouble giving them access to government safety nets. Although the deposit insurance was first to be introduced, government safety net also includes lending from the central bank to troubled institutions as part of the central bank’s lender of last resort role or exceptional, direct government infusion of cash into TBTF institutions in form of too-big-to-fail policy (Mishkin 2005).

The extension of government safety net is an indicator that TBTF problem has grown. Today TBTF have gained many variations in the literature that reflect different aspects of the problem: “too-big-to-liquidate,” “too-big-to-unwind,” “too-connected-to-fail,” “too-systemic-to-fail,” “too-complex-to-fail,” “too-big-to-discipline-adequately,” “too-big-to-regulate,” “too-big-to-manage,” “too-political-to-fail,” among others. Each of these aspects reflects particular set of problems that arise in dealing with large, systematically important financial institutions.

This policy is often justified by the fact that these institutions are too connected or too systemic to fail. Such a failure could have ramifications for other financial institutions and therefore the risk to the financial system and economy would be enormous (Helwege 2010). The regulators try to prevent pervasive financial fragility that occurs because the failure of one firm leads to the failure of other firms which cascades through the system, or when a number of financial firms fail simultaneously. These mechanisms termed systemic risk are usually the motive that propels regulators toward intervention.

However, policymakers may also intervene in order to maximize personal welfare or because they view government influence over the allocation of credit as increasing society’s long-run welfare (Stern and Feldman 2004) meaning that these institutions are too-political-to-fail. Also the national prestige plays an important role by making the decision to rescue a company. In general, the financial crisis and government intervention have shown that nationalism and protectionism have received upswing.

Whatever the intervention incentives are, there are always adverse implications that it leads to. If they decide to rescue the financial firm, what is usually characterized as “bailout”, regulators impose a range of negative effects that are qualified as efficiency costs and resource misallocation (Stern and Feldman 2004). Beside the fiscal costs of a government intervention that are financed with taxpayer money, there are also some indirect effects. First, the intervention may distort competition in the market. The favoring of large institutions leads to their higher ratings, lower costs of capital, better stock performance and higher profitability. Second, TBTF guarantee attenuate market discipline, which leads to impaired incentives of market actors, resulting in moral hazard problems and inducing excessive risk-taking. Financial institutions also tend to become larger and riskier in order to obtain TBTF status.

Essentially, the appropriate policy response weights the trade-off between preventing systemic risk and moral hazard problems (Helwege 2010). That trade-off depends critically on costs and benefits of an intervention. Although the regulators, at least theoretically, are able to distinguish costs and benefits, in practice this is usually not so easy given the available information about costs and benefits and its exceedingly complex nature. Moreover, there are several key aspects of the matter that require special analysis, where too much or too little of a measure can have disastrous consequences. This set of problems requires closer illustration.

Economic action in free market economy requires a framework which allows and protects as possible free action of market participants, and thus as possible undistorted functioning of the market. The actual terms of this framework depends on the functional conditions of the market. The financial markets are characterized through high degree of uncertainty. The demand for maximum safety in the financial market would not only disrupt them, but also constrain investments and with it the growth of the real economy. Therefore, it applies exactly to financial markets that the government regulation should not restrict individual freedom of market participant to assume risks.

On the other hand, the greatest possible freedom of market participants to choose their actions related to investment opportunities also means that they have to be prepared to bear the consequences of their risky actions. Not the government, but the market determines the success of a business ideas or companies. Therefore, the company that is not able to sustain in the market, should also be allowed to resign. The shifting of the negative implications to the general public would also be a substantial limitation of its freedom, as the taxpayers are requested to finance the bailouts regardless of their willingness to do so, leading to social unrest.

The question of the responsibility is of special concern exactly in financial sector because of its wide extent of risk-taking possibilities. Hence, accepting the responsibility in the financial sector has a disciplinary role. Currently, “too big to fail” market participants get opposed incentives. Their failure could have adverse effects on other financial institutions in chain reaction and may also lead to substantial impairment of the financial markets. Knowing that they are of systemic relevance and that the government would bail them out in the case of failure would give them incentives to assume excessive risks more than they are able to bear. TBTF institutions assume more risk in an attempt to take advantage of this preferential status in a short-run. This problem, better known as “moral hazard”, means that financial institutions knowing that they are “too big to fail” will change their behavior and by taking risky bets they could increase the systemic instability.

The problem is that the mechanisms responsible for effectively preventing moral hazard and undesirable risk-taking are impaired. The undesirable behavior of large, complex financial institutions is neither restrained effectively by supervision and regulation nor by the market place (Stern 2009). The deficiencies of supervision and regulation are expressed in the fact that these institutions are too big to regulate effectively, but also the deregulation of financial industry plays an important role. Moreover, market discipline is also not the credible check on the risk-taking of these firms. When the creditors of the failing TBTF institutions expect government protection, they have fewer incentives to monitor and respond to the activities of these institutions, which represent another materialization of “moral hazard”. As a result of the reduced control the systemically important institutions may take excessive risk, making risky loans and other bets.

Additionally, policymakers and regulators confront difficult choice by deciding to which of the two objectives of the macroeconomic policy they give priority, preserving system stability or free competition in the market. The policymaker is required to act neutral in terms of effect on competition and to impose clear rules that encourage such a competition. However, by deciding to bail certain market participants out, the policymakers maybe improve financial stability temporarily, but, on the other hand they grant them a preferential status and distort market competition. As a result of the preferential treatment, TBTF financial institutions will dominate the market and squeeze smaller institutions out of the market. In that case, market forces and competition lose purpose of disciplining and balancing the market, and become instruments of both governments and large financial institutions with dominance and guaranteed protection.

Moreover, the realistic threat is that the provision of bailouts may not end the instability of the system at all. It may even amplify inefficiencies and resource misallocation further causing greater instability. This means that TBTF protection does not prevent banks from repeating risky practices, which both increase financial instability and make additional bailouts even more realistic. Furthermore, governments’ commitments to the provision of guarantee have weakened confidence in countries’ long-run solvency. The high fiscal costs of bailouts lead to alarmingly high budget deficit and public debt. It is not surprising that too big to fail problem is rising further threatening to become what experts have already noted as “too big to rescue”.

But what is the alternative? Should the regulators let this institutions fail? Hetzel (1991) noted that the policy of “too big to fail” resulted from a fundamental deficiency of bankruptcy law for banks. It is the problem of timely closure of large financial firms that highlights the features of these institutions as being too-big-to-liquidate or too-big-to-unwind. Therefore, there is a need to close insolvent and nearly insolvent financial institutions promptly. This task is not easy to accomplish not only because of the large size of failing institution, but also given the fact that the institution might be viable if restructured.

In order to summarize the discussion, the conclusion can be made that, by considering each and all of the aspects of TBTF problem, the term includes two main components (Stern and Feldman 2004):

1. The existence of the policy that protects uninsured creditors from the losses they might suffer and
2. The existence of too big financial institutions.

The further discussion of TBTF relies on examination of the effects of these two basic elements’ existence as well as their importance for dealing with TBTF. Important questions are: What made these institutions too big to fail and why did government bail them out? What are the consequences of the bailout? How to prevent TBTF in the future?

Finally, as mention above, too-big-to-fail policy perhaps has positive impact on stability of the financial system in the short-run, but it is not durable solution for the failure of systemically important institutions. This policy generates uncertainty in the market and emphasizes the frustration of the policymaker with the failure and liquidation of such an institution. Too big to fail is only ad hock measure that amplifies moral hazard problem, distorts competition and decrements financial stability in a long-run. It also attenuates civil liberties. It leads to emphasize of even greater imbalances that threaten to materialize in the future with even greater intensity. By using this measure we only bought ourselves a few years, which should be wisely used to introduce comprehensive financial system reform and reassess postulates that our society is build on.


The financial services industry includes several different types of institutions that accommodate different needs – depository institutions, insurance companies, investment banks, finance companies, mutual funds, and hedge funds. All these institutions have a different role in the financial intermediation process, but the depository institutions and investment banks are those that require closer attention.

Instead of keeping their money in cookie jars, individuals rather invest it in financial intermediaries, where their deposits are considered as safe place to save and where they can earn some interest on it. These intermediaries, which include commercial banks, saving and loan associations, credit unions, and other types of institutions, accept money from individuals and hold it in different types of accounts. Customers’ deposits are on the liability side of these institutions and they use them to provide loans that are on their assets side. Loans might be used for personal purposes, such as to purchase cars or homes, or might be intended for commercial use, such as to start or expand a business.

In order stay in business in the long run, the interest these institutions earn on their loans and investments must exceed the total interest they pay to depositors and creditors. It means that they must be able to make enough on the spread between their assets return and the interest they pay out to their depositors (Kane 1989, 4). The financial firms seek to increase this spread by reinvesting the funds raised from depositors into high yielding assets. As a result of wide extent of risk-taking possibilities and because of the necessity to safeguard the interests of depositors and investors, banks are the main focus of regulatory scrutiny.

Regulatory framework that sets the incentives to hold banks taking of risk within the certain limit is usually concentrated on preserving the sufficient level of capital reserves held by an institution. Capital reserves, denoted as ratio of capital to assets, are required to start and maintain business. When the loans bank made default or when the value of investments banks keep on their balance sheet decline sharply, they should have sufficient capital reserves to continue to operate despite the incurred losses. In addition, when a bank has its own funds at risk as well, it will commit only to reasonable investments.

On the other hand, investment banks, unlike commercial banks, do not provide checking and savings accounts or any of the traditional banking services. Investment banks underwrite and trade securities. Beside stocks and bonds, securities also include derivatives, such as swaps, forwards, options, futures, swap-options, and asset-backed securities. The underwriting of securities involves advisory and marketing services for companies interested in issuing stocks or bonds. Investment banks recommend the price the company should ask for the offering and advice the company on the application to the Security and Exchange Commission (SEC) for permission to offer the security. Marketing services include preparation and distribution of the prospectus that provides the detailed information about the company and the intended security sale. Trade of securities is conducted on an exchange. Investors are allowed to trade securities trough brokerage houses and online discount brokers. Stocks and bond are traded on a stock exchange, for example New York Stock Exchange, and derivatives are traded on the over-the-counter markets (OTC), such as the National Association of Securities Dealers Automated Quotation System (NASDAQ). Many investment firms were engaged in underwriting, advising, and trading of securities, and many were very successful in doing it.

Another important element of the financial service system is central bank. Central banking system of the United States is called Federal Reserve (FED), created in 1913. One of its key objectives is to ensure that the credit system remains stabile and functional. The Fed regulates banks that are members of the Federal Reserve. All members of the Federal Reserve System are required to hold a reserve of funds to meet short-term demands, called the reserve requirements. Members benefit is that they are allowed to borrow funds from the Fed and from each other. However, the Fed restricts the types of assets that member banks could hold.

The Federal Reserve is responsible for determining the federal funds target rate, the discount rate, and the reserve requirements, mentioned above. The federal funds rate is the one at which banks can borrow from each other excess reserves. In order to meet reserve requirements banks lend to each other short term, usually overnight, using interbank funding market. Discount rate, on the other hand, is the rate at which banks are able to borrow from the discount window at the Federal Reserve. The federal funds rate is very important tool for guiding the direction of the economy, because all other interest rates adjust to this rate. By lowering it, Fed is able to provide flow of cheep credit that can be used for consumer spending or expansion and investment of businesses.

Regarding the various functions of different financial institutions, the financial system is at the center of the growth of the economy. Financial institutions encourage, collect, and transfer the savings necessary to finance the nations’ economic growth (Kaufman and Kroszner 1996). Banks and other financial institution are responsible to facilitate uninterrupted functioning of payment system, to provide credit for productive investment opportunities, to monitor private enterprises, and to execute government policy that guide the direction of the economy (Mishkin 2005).

The financial sector mobilizes savings and allocates credit across space and time (Herring and Santomero 1995). The primary role of the financial sector is to bringing together savers and borrowers so as to allocate capital, which is used for most productive investment opportunities, the process which maximizes the risk-adjusted return to savers. In addition to marshalling savings, further function of banks and other financial institutions are to monitor private enterprises. In order to obtain credit from a bank, private enterprises have to satisfy number of requirements, which progress of implementation is tightly controlled by banks. Thus, banks also ensure that the financial resources are effectively and productively invested in order to maximize the profits. Furthermore, financial system is an important conduit through which central bank policy influences prices and economic activity (Kroszner 2010). Financial institutions are the key intermediaries between the governments (central banks) and the rest of the economy in the context of the country’s monetary and credit policy. This function is primarily pursued through their deposit and lending activities as well as their role in nation’s payment system.

Giving regard to the unique function of the financial system and its central place in the economy, problems at banking and financial institutions are widely believed to be more likely to spread quickly throughout the financial sector and then broadly throughout other sectors and the macro-economy as a whole. If a large number of banks fail at the same time, leading to banking panic, the economy’s ability to channel funds to those with productive investment opportunities may be severely impaired, causing a full-scale financial crisis and a large decline in investment and output. Indeed, some of the worst economic downturns are almost always associated with banking panics and financial crisis (Mishkin, 2005). In this regard, regulators are especially devoted to maintain stability in the financial sector and to mitigate potential adverse spillovers. Therefore, the employment of governments’ financial safety net, and particularly too-big-to-fail policy, is considered to be of substantial importance exactly in the financial sector.


The result of the unique function of the financial service system and its central place in the economy, regulators are especially devoted to maintain stability by preventing runs and panics in financial system and mitigating contagion potential. These concerns have led most governments throughout the world to provide safety net for banking system. Government safety net includes, among other policies, deposit insurance (explicit and implicit), lender of last resort facility and too-big-to-fail policy (TBTF).

Prior to safety net regulations U.S. banks held higher capital to asset ratios (Kaufman and Kroszner 1996). Large banks did not frequently become insolvent, even in times of widespread bank failures and macroeconomic downturns. Similarly, prior to the introduction of the lender of last resort in the US, the failure rate of banks was lower than that of non-financial firms, and losses to depositors and other bank creditors were lower than for creditors of non-financial firms. In addition, the government regulators did not have authority or resource to assist these banks if they had become insolvent (Kaufmann 2002). Banks failed when they were not able to meet depositor claims or when regulator believed that they did not have sufficient capital and they would default. The banks were forced to suspend operations and were either recapitalized or liquidated.

However, then came the Great Depression. In response to stock market downturn and subsequent crash in October, 1929, depositors attempted to convert their deposits into cash. Under this circumstance banks were unable to satisfy all of these demands, what caused them to fail leading to contraction of money supply (Bernake 1983). As a result, many other solvent banks also failed. Around 9000 banks failed during this period (Helwege 2010). The fact that so many financial institutions failed means that both the money supply and the amount of credit in the economy fell as well causing a large drop in economic activity (Friedman and Schwartz 1971).

In an effort to improve the conditions of financial service industry during the Great Depression, Congress enacted the Glass-Steagall Act (GSA) of 1933, which main objective was to separate commercial and investment banking activities. Banks were prohibited from engaging in many types of investment banking transactions, such as to underwrite or trade corporate stocks and bonds (Cohen 1994). Equally, investment banks were prohibited from engaging in activities of commercial banks. It also reduced conflict of interest by restricting investment bank directors, officers, employees, or principals to serve in commercial banks.

GSA also aimed to eliminate competition among banks by introducing an interest-rate ceiling for deposits, under Regulation Q. The wide spread opinion was that interest rate competition among banks contributed to the instability and bank failures of 1930s. General perception was that if the banks have to compete for depositors by offering high interest to attract them they would in turn acquire risky assets that offer higher return in order to uphold their profits. As this scenario may jeopardize the viability of the commercial banks, the GSA set interest ceilings of zero on demand deposits and limit the rates on time and saving deposits. Therefore, the Regulation Q of Glass-Steagall Act limited banks risk-taking.

In addition, GSA established Deposit Insurance Corporation (FDIC), which started its operations in 1934. The FDIC responsibility was to insure bank deposits in the event of failure, and consequently to prevent runs and panics. All member of the Federal Reserve System had to participate in the FDIC program, which was similar to a regular insurance policy. The FDIC charges the bank a premium, and, in the event of failure, depositors are guaranteed the return of their money up to the sum insured. The initially set insured value was $2,500.

At the beginning FDIC protected depositors holding small accounts (Hetzel 1991). It responsibility was to cover losses of insured depositor of already failed banks. Not to keep insolvent banks in operation. However, in 1950 the authority of FDIC was widened. It was allowed also to prevent a bank from failing if the bank was perceived essential to provide adequate banking service in its community. In 1971, Unity Bank in Boston became the first bank bailed out, which services were considered essentiality for the community. The motive was the fear that the failure of a bank considered to be a black institution would set off riots in black neighborhoods. This precedent rose concerns that doing the first bailout would lead to many more. And exactly this has happened. Shortly afterwards the FDIC rescued large, mismanaged Bank of the Commonwealth in Detroit for the same reason.

Trough the 1970s the FDIC acted to protect all depositors, although not shareholders, at nearly all failed banks. The usual practice of FDIC was to merge the failed banks with the solvent banks, to assume some or all bad loans or to guarantee to repay the losses that assuming bank might incur (Sprague, 1986). This procedure, termed purchase and assumption, was used in resolving the failure of the Franklin National Bank (New York) in 1974, which was the twentieth largest bank in the country at the time. It was essential for the community because of its large size. After becoming insolvent, Federal Reserve supported the bank by the large-scale discount window, which kept it in operation. But, as it failed to restore it to profitability, the bank was subsequently sold. Also the Pennsylvania Bank (Philadelphia) was deemed essential for the community because of its large size. Only this time the shareholders were left intact, although the FDIC made some changes in management and directors.

In the same time period there is an evident aspiration of banks to expend their business, while the Federal Reserve always tried to keep them in check by applying new regulation (Bonnick 2009). Financial institutions were looking for ways to avoid the various regulations and expand their business, because banks considered the existing regulations as hindrance of their competitive ability and limitation of their growth. One such attempt was creation of Bank Holding Companies (BHCs), which allowed banks to pursue both banking and non-banking activities and to escape State laws against branch banking. This legal construction would acquire multiple banks and were referred to as “multi-bank holding companies.”

In order to respond to the need to protect the public from monopoly and concentration of economic power, Congress enacted the Bank Holding Act of 1956 (Hall 1965). According to it states could decide whether they allow BHC to acquire locally operated bank. However, most states did not allow this, and, essentially, BHCs were prohibited from operating banks across state lines. The Act also restricted bank holding companies from engaging in most non-banking activities or to acquire voting securities in companies other than banks, and protected the public from undesirable expansion by holding companies. The Bank Holding Act was one of the several attempts to enable efficient regulation of banks and to limit banking activities to some extent. Regulators feared that, if the banks could operate subsidiary banks in other states, their ability to control these large organizations, which tend to take too much risk in competitive environment, would be substantially crippled. Although Bank Holding Act was well designed to meet the requirement for limiting banks to grow, it also provided a loophole. It stated that holding company may own a non-banking subsidiary that performs services "closely related" to banking activities if they had approval of the Federal Reserve.

Over the time, federal interest rate ceiling, produced by Regulation Q, started to affect banks’ ability to attract deposits. As a result, they could not meet loan demands at this rate and began losing deposits to investment institutions, which were not restricted in such a way. With decrease of banks deposit base, their engagement in provision of loans was also decreasing, affecting their profits, which all resulted in Savings and Loan crisis of 1970s and 1980s. Also the innovations in the financial industry and development of new communication and computer technologies have increased competition for banks. The rise in importance of capital markets followed by financial liberalization and deregulation caused emergence of new competitors, leading to expansion of financial institution into riskier activities.

As a result of continuous problems in depository institution, because banks were losing deposits to investment institutions that were not subject to the interest rate restriction, banks sought to find method to challenge interest rate restriction and increase their competitiveness. In this regard, they developed money market accounts and Negotiable Order of Withdrawal (NOW) accounts (Hetzel 1991). Both measures allowed banks to offer depositors higher rate of return and attract more funds. However, by 1980, the number of failing depository institutions increased. In order to deal with this issue of disintermediation, withdrawal of funds from traditional depository institution to be put directly into investment firms that offered higher returns, the Depository Institution Deregulation and Monetary Control Act (DIDMCA) was passed in 1980. The main purpose of this act was to remove ceilings on the interest rate banks could offer depositors (Morris 2004). The new legislation introduced healthy competition in financial sector by allowing banks to retain existing depositors and attract new ones.

Despite these regulatory changes, between 1980 and 1982, 118 savings and loan banks failed (Bonnick 2009). In response to the continued and growing problems in the industry, the Garn-St. Germain Depository Institutions Act (GSGDIA) of 1982 was passed. The act was another step in making depository institutions more competitive in comparison with non-depository financial firms. More explicitly, the act was relief measure for thrift industry (Graddy et al. 1994). The legislation also allowed for adjustable rate mortgages, which aimed to encourage home ownership. As a result, the savings and loan banks began to offer a larger number of consumer loans and risky mortgages. Both regulatory changes aimed to help depository institutions to survive by allowing them to expand. These institutions began to increase their firms’ funding base and to invest new funds they raise into a speculative manner. The idea was “to grow out of problem” by undertaking risky bets. If it pays off it will be good, if not, the problem belongs to government as a result of the deposit insurance (Kane 1989).

An additional change was that the Act gave regulatory agencies power to deal with troubled banks and thrifts. The FDIC and FSLIC were empowered to step in and do whatever was necessary to protect an insured institution, which was closed or about to be closed (Cornett and Tehranian 1990). Therefore, the FDIC broadened the scope of it operation and protected not only depositors of already failed banks but also prevented the failure by protecting all depositors and even creditors and shareholders. The FDIC began to view the problem that the protection effectively eliminated incentives for large depositors to monitor and discipline their banks. In order to restore incentives the FDIC experimented in 1983–1984 with allowing banks to fail and not protecting uninsured depositors (FDIC 1997).

Soon afterward the caution overrode experimentation when the insolvency of Continental Illinois in 1984 caught regulators unprepared to deal with such a large institution. At the time Continental Illinois was both the seventh largest bank and the largest correspondent bank having interbank deposit and Fed funds relationships with more than 2,200 other banks. The reason for the failure was the fact that the bank grew rapidly by purchasing $1 billion in oil and gas high-risk loans. Beside the 10 percent of Continental’s insured depositors, the FDIC also protected all other depositors from losses. The intervention consisted of the Federal Reserve Bank of Chicago assistance with discount window loans, which eventually totaled $7.6 billion, and FDIC purchase of $1 billion in preferred stock from Continental’s holding company. As a result Continental was allowed to remain in operation despite of its irresponsible risk-taking behavior.

The Continental Illinois was the first bank alluded as being “too big to fail”. On the hearing before the Congress, Congressman McKinney uttered the now famous phrase: “Mr. Chairman, we have a new kind of bank. It is called too big to fail, TBTF and it is a wonderful bank” (Morgan and Stiroh 2005). Comptroller of the Currency testified that any of the 11 largest multinational banks were unlikely to permit to fail. The next day Wall Street Journal headlined a lengthy article on the hearings “U.S. Won’t Let 11 Biggest Banks in Nation Fail—Testimony by Comptroller at House Hearing Is First Policy Acknowledgment” (Carrington 1984). And so, TBTF was born.

Following the case of Continental Illinois bank, FDIC tried to narrow the scope of TBTF and to reintroduce market discipline, but the definition of “big” institution was broadened and progressively reduced to eventually include even the US$ 2 billion of National Bank Washington (DC), which was only about the 250th largest bank in the country and, apparently, more “too political to fail” than TBTF (Kaufman 2002). When the National Bank of Washington was closed, FDIC as receiver provided the coverage also for foreign depositors at the bank’s off-shore office in the Bahamas. Prior to the closure, the discount window lending by the Federal Reserve permitted sizable portion of uninsured deposits to be withdrawn, although the bank would have failed earlier.

The following takeover of the Bank of New England and Maine National Bank amplified the problem further and made clear the government safety net was expending, the criteria for bailing out uninsured creditors had broadened, the coverage had been expended and the kinds of protected liabilities increased. Banks relied on deposit insurance as an aid in competing with other financial institutions, because provided a subsidy to banks by lowering their costs of funding (Hetzel 1991). The additional extension of the government guarantee in the form of the policy of too big to fail, as mentioned above, substantially hampered the contraction of banking industry. The massive use of the financial safety net was justified by the fact that banks are inherently fragile and prone to runs and panics. Especially after the Diamond-Dybvig model (1983) this thesis was supported. Because the banks’ assets are being held long-term, and their liabilities short-term, the sudden withdrawal of funds by depositors may result in run on bank leading to failure, although the bank may be solvent. If the repayment for depositors is guaranteed, there is no need to withdraw the funds and run the bank.

However, it seemed that despite of financial market deregulation and expansion of financial safety net, these institutions were not able to survive. During the period between 1980 and 1988, over 500 savings associations failed (Clark et al. 1990). The frequent interventions of the regulators resulted in the failure of the Federal Savings and Loan Insurance Corporation (FSLIC), because it had guaranteed so many failed savings and loan banks. Also the bank insurance fund was technically insolvent for a brief time. This drew considerable attention on the fragility of the U.S. deposit insurance funds and emphasized the need for regulatory reform to restrain the use of TBTF policy. The thesis that rescuing troubled banks leads to moral hazard and distorts market discipline, which both result in irresponsible behavior and excessive risk taking, was empirically proven.

This resulted in passage of Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) in 1989. The act aimed to recapitalize the deposit insurance fund for saving associations, to improve resolution of the outstanding and anticipated failures of savings institutions, and to provide better regulation of these institutions to prevent future insolvencies (Clark et al. 1990). The FIRREA eliminated FSLIC and created two new insurance funds: the Savings Association Insurance Fund (SAIF) and the Bank Insurance Fund (BIF), both under the supervision of FDIC. The contributions of member-banks to these funds were based on the risk of banks. Banks belonging to the higher risk categories were required to pay higher premiums (Ennis and Malek 2005).

Another regulatory change that aimed to restrict the use of the financial safety nets came soon afterward through the implementation of the Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991, which was designed to restore the incentives that discipline undesirable behavior and prevent moral hazard. The Act introduced prompt corrective regulatory action (PCA) and least cost resolution (LCR) (Kaufman 2002). The new law explicitly permitted the FDIC only to protect insured depositors up to the limited maximum, making an exception only in situation when the failure would cause serious adverse effects on economic conditions and financial stability. The exception criterion known as “systemic risk” was conditioned by the necessity of joint approval of FDIC, the Federal Reserve, and the Treasury Secretary in consultation with the President. In addition, the legislation limited Federal Reserve discount window advances, made the process of failed bank resolution more efficient, and reduced chances for system-wide spillover following the bank failure. The regulatory reform made it more difficult for FDIC to protect uninsured depositors and creditors at large failing banking organizations and TBTF banking organizations. TBTF policy was forgotten for some time, surrounded by mystery that was personified in the notion of systemic risk, which everyone heard the stories about and secretly believed in its existence.

In addition to the limitation of the financial safety net in the late 1980s, regulators started to evoke the idea that banks needed to expand their business models in order to survive without government aid. In the same time, section 20 of the Glass-Steagall Act that prohibited commercial banks from affiliating with investment firm, came under stronger criticism from the banks. As a result of the mounting pressure, the Fed permitted in 1986 securities subsidiaries of bank holding companies to underwrite and deal in certain bank ineligible securities, under the condition that revenues from such underwritings constituted less than 5 percent of the subsidiary’s gross revenue (Roten and Mullineaux 2002). This move was the first indicator for appeal of GSA and removal of commercial and investment banks separation. In 1989, J.P. Morgan was the first bank permitted to underwrite corporate debt securities, and in 1990, the company acquired permission to sell stocks through a subsidiary. The same year the amount of total revenues that non-banking subsidiary of a bank holding company is permitted to derive from underwriting and dealing in securities was increased to 10 percent.

Furthermore, in 1990 Citibank also challenged the Fed’s interpretation of section 20 of the GSA. In December 1996 the Fed accommodated banks and announced that it was increasing raised the revenue ceiling on ineligible underwritings, from 10 to 25 percent. This allowed banks to expand their securities business even further without violating the Glass-Steagall Act. During 1998, for example, three of the top 10 underwriters of US stocks and bonds by dollar volume were affiliated with bank holding companies (Salomon Smith Barney, JP Mogan, and Chase).

The final step in abolishing of Glass-Steagall Act was the enactment of the Gramm-Leach-Bliley Act (GLBA) in November 1999, also known as the Financial Modernization Act. This act repealed provisions of the Bank Holding Company Act (BHCA) of 1956 that provided for the separation of commercial banking from insurance activities. These modifications of the existing federal banking law introduced the financial modernization in the United States by establishing a legal structure that allows for the integration of banking, securities and insurance activities within a single organization (Barth and Jahera 2006). The law allowed new Financial Holding Companies to own subsidiary corporations involved in any activity that is financial in nature. Therefore, the act promoted consolidation within the financial service industry.

The Gramm-Leach-Bliley Act merely formalized what had already been happening in the financial marketplace, this being affiliation between Federal member banks and institutions involved in securities business. The act also repealed the prohibition of officials of securities firms serving in supervisory positions in member banks.

Another key feature of the new financial service legislation is a shift toward functional regulation of financial institutions, changing the allocation of authority among regulators. According to the new regulatory system, authority is allocated based on the nature of the activity being performed (Barth et al. 2002). The functional regulation has meant that banking regulators regulate bank activities, securities regulators regulate securities activities, and insurance regulators regulate insurance activities.

Since the Gramm-Leach-Bliley Act, the financial industry has changed substantially. The deregulation of the financial industry has paved the way for innovation and introduction of new products and practices, internationalization, and consolidation of the financial sector. The deregulation together with other transformations of the industry is considered responsible for setting the stage for the latest financial crisis.

This period was characterized by the further innovations in the financial industry and development of the model of securitization that use structured financial products to easily produce and exchange risk. Further internationalization, deregulation and domestic and international liberalization made financial industry as a global game, which shifted from traditional banks to the capital markets and off-balance sheet activities. These changes have increased the competition resulting in a merger boom from 1990-2005 and market consolidation (Jones and Oshinsky 2006). The system became detrimentally complex and interconnected with low density and faster execution of operations.

Prior to the financial crisis that started in mid-2007 and extended into 2009, there were debates about whether the TBTF policy was completely eliminated by the FDICIA reform. However, the question of whether some institutions, even after FDICIA, may still be TBTF has become trivial in light of the dollars the federal government has recently poured into bailing out those banking organizations considered TBTF and/or too interconnected (e.g., Bear Stearns, American International Group [AIG], Citigroup, and Bank of America) (Brewer and Jagtiani 2009). It is evident that the TBTF policy is at work in the financial crisis, since these large financial organizations have been receiving special treatment and support.

There is also the argument that FDICIA reform of 1991 has actually formalized the process for bailing out TBTF institutions by specifically allowing a TBTF bailout when the banking organization’s failure would have serious adverse effects on the economy or financial stability. It indicated the way how to become TBTF and collect protection.

TBTF policy has recently been extended beyond banking institutions to cover nonbank financial institutions as well. The rescue of Bear Stearns and AIG and the various new lending programs that currently allow nonbank institutions (such as primary dealers) to have access to the discount window mark a vast expansion of the government’s financial safety net beyond depository institutions. More nonbanking institutions have come under the umbrella of TBTF banking institutions through the mergers supported by the federal government and bank regulators, for example, the regulator-assisted acquisitions of Merrill Lynch by Bank of America and Bear Stearns by JP Morgan Chase and Company (JPMC). For the first time in the history of the Federal Reserve System, discount window access was extended to investment banks. Beside commercial and investment banks TBTF policy is also expanded to include insurance and even car companies (Stiglitz 2009a).


The most basic cause of the subprime crisis is the tendency of financial normalization and innovation to run ahead of financial regulation (Eichengreen 2008b). Deregulation and policies of domestic and international liberalization have been the trend not only outside, but also within the financial markets. By comparing the present economic crisis with the Great Depression, Eichengreen points out that the deregulation, as one of the major causes of the financial crisis, has offset the separation of commercial- and investment-banking arms of large financial conglomerates. The elimination of the Glass-Steagall Act brought about the tendency for the investment-banking division run by individuals with high risk tolerance to gamble the funds of small retail depositors once again. Without having access to retail deposits and with money market instruments closely regulated, investment banks would use their partners’ capital for funding and would not need access to financial safety net.

Beside the removal of the Glass- Steagall Act in 1990s, also the deregulation of commissions for stock trading in the 1970s and removal of ceilings on interest on retail deposits in 1980s that raised competition in the financial markets have led to increase in dimensionality, complexity and international interconnectedness of the financial sector. For investment banks and other financial institutions this was the clear signal for the financial innovation that has introduced new business models and riskier operations. The “originate and distribute” activities, development of “mortgage- backed” securities, “collateralized debt obligation” and “credit default swaps”, but also improved financial infrastructure, which increased the connectivity of financial firms and complexity of the system, are only part of the problem.

Furthermore, greater competition and ambition to increase profitability have also propelled the financial institutions to pursue these new lines of business. The investment banks were encouraged to use more leverage and to fund themselves through the money market. The commercial banks responded on this request by placing their overnight deposit money at the disposal.

As a consequence a fragmented regulatory regime suitable for segmented financial-service industry was not adequate to keep pace with these radical changes in the financial industry. The new financial system has become global, interconnected and complex what goes beyond the policy makers’ and regulators’ ability for supervision and control. The regulatory policies were not adopted to the new environment, what left no other choice but to make ad hock decisions in managing the crisis.

All changes in the regulatory framework already described have led to excessive lending and spending boom. Credit has become cheaper and widely available. Lending standards eroded. The major financial institutions even pushed the use of credit by subsiding mortgage loans. This in turn created artificial demand for housing and has driven the housing prices up leading to the bubble.


The financial internationalization was responsible for the large capital inflows in the US. Beside that it led to division of investment and commercial banks, the Great Depression similarly imposed restrictions on international capital flows. From the 1970s, these restrictions have been relaxed step by step.

On the other hand, previous financial crises that occurred in the emerging markets in the 1990s also brought some changes. The collapse of East Asian economies, Russia’s default, and severe stresses in Argentina, Brazil, and Turkey propelled these counties toward less borrowing, costs and consumption reduction and subsequently more saving. This made more financial capital available, which was used to finance credit boom in the US.

Foreign funds mostly came from Asia. Chinese savings of nearly 50 per cent of its GNP together with the decline of investment in Asia following the 1997-1998 currency crisis has created surplus funds that were channeled into US Treasury securities and the obligations of the Federal Home Loan Banks (FHLB), Fannie Mae and Freddy Mac (Schneider and Kirchgässner 2009). These capital inflows upheld the dollar. The outcome was the reduction of the costs of borrowing in the US on some estimates by as much as 100 basis points, encouraging them to live far beyond their financial means (Eichengreen 2008b).

The internationalization and foreign financing of the US economy was only partially the reason that the interest rates were low for such a long time (2003 - 2006). Other reasons for the lax interest-rate policy lie in the 2001 recession. In response to the burst of Internet bubble, the Federal Reserve reduced interest rates and did not counteract the build-up of the housing bubble (Brunnenmeier 2009). Taylor (2009) suggests that solely the departure from interest rate policy historically followed might be sufficient foundation for the subprime crisis. Furthermore, the Bush administration cut taxes. That led to large budget deficit meaning that the government was not saving. Also the measured household savings declined into negative territory. The result of these developments was the increased consumer spending between from 2002 and 2007, which has introduced domestic and international imbalances.

However, for all mistakes were not only the policies and regulators responsible. The successful Chinese formula for growth was to export manufactures in return for high-quality financial assets. Money became cheap available for everyone. The American dream came true. An opportunistic market that believes in easy earnings was created. The demand for “high quality” securities was there and the financial institutions only needed to produce them. “Originate and distribute” model looks as a logical choice.


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Too Big To Fail - Concepetual Disputation with Leopold Kohr
Vienna University of Economics and Business
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Too big to fail, Leopold Kohr, Übergroße, Asset bubbles, Ponzi scheme, systemic risk, moral hazard
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Vidak Saric (Author), 2011, Too Big To Fail - Concepetual Disputation with Leopold Kohr, Munich, GRIN Verlag,


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