Too Big To Fail – Some Regulatory Dots Connected But Still A Way to Go….

By George Gilligan, UNSW

SYDNEY: 4 November 2014 – In a recent article on the CLMR portal (22/10/14), I examined contemporary international efforts to reform financial benchmarks in the wake of the Libor and Forex scandals, in which the G20 has been prominent through the activities of the Financial Stability Board (FSB). In preparation for the imminent G20 Leaders Summit to be held in Brisbane from 15-16 November 2014, the G20 has identified four core priority areas for its financial regulation reform pathway: 1. Build resilient financial institutions; 2. End too-big-to-fail; 3. Address shadow banking risks; and 4. Make derivatives markets safer. This analysis piece will discuss the too big to fail phenomenon in financial markets.

What is too big to fail and what is the term’s etymology?

The debate about too big to fail centres on the issue of whether various large financial institutions are so strategically important and inter-connected within financial markets, that they simply cannot be allowed to fail by national governments due to fears of systemic financial contagion. The various pros and cons of this debate are discussed in more detail below, but first a comment on the etymology of the term. There is a common assumption that the term too big to fail is a product of the most recent Global Financial Crisis (GFC) of 2007 onwards, especially regarding the Emergency Economic Stabilization Act of 2008 (EESA), when the US Government established the Troubled Asset Relief Program (TARP), which was effectively a US$700 billion bailout of private sector US financial institutions funded by US taxpayer revenues. However, the term too big to fail has a longer pedigree and can be traced back to Republican Congressman for Connecticut, Stewart B. McKinney, speaking at Congressional hearings on 19 September 1984. Those hearings related to a possible bailout of Continental Illinois, not only at that time the seventh largest bank in the US, but also facing insolvency due to riskily aggressive lending policies (sound familiar?). Representatives for Continental Illinois argued that it should be bailed out with taxpayers’ money because if it was allowed to fail it would endanger many other US banks and the US economy itself. In response to their entreaties Congressman McKinney noted presciently: ‘Let us not bandy words. We have a new kind of bank. It is called too big to fail. TBTF, and it is a wonderful bank.’ Whether Continental Illinois was indeed a wonderful bank is open to question and in time it became a part of Bank of America, but it was a precursor of the more recent TARP program in that it did receive $4.5 billion in taxpayer funds from the Federal Deposit Insurance Corporation (FDIC) in order to stay in business.

After the rescue of Continental Illinois the too big to fail label largely disappeared from the front page headlines until the GFC hit and governments and regulators around the world scrambled to inject stability into global capital markets. Several extremely large financial institutions in different countries received enormous amounts of taxpayer funds to ensure their financial survival. For example, the TARP program was established in the US and in the UK some financial institutions such as Northern Rock and the Royal Bank of Scotland were virtually nationalised and are still effectively in the ownership in the UK taxpayer, although the UK Government’s goal is to return them to private sector ownership. Then chair of the US Federal Reserve, Ben Bernanke, when he gave evidence before the Financial Crisis Inquiry Commission in Washington DC on 2 September 2010, defined the term too big to fail and the rationale underpinning its approach to utilising public funds to stop large financial institutions from going out of business in these terms: ‘A too-big-to-fail firm is one whose size, complexity, interconnectedness, and critical functions are such that, should the firm go unexpectedly into liquidation, the rest of the financial system and the economy would face severe adverse consequences.’  Mr Bernanke justified such an approach in extreme circumstance such as the GFC because: ‘Governments provide support to too-big-to-fail firms in a crisis not out of favoritism or particular concern for the management, owners, or creditors of the firm, but because they recognize that the consequences for the broader economy of allowing a disorderly failure greatly outweigh the costs of avoiding the failure in some way.’

So the core justification for too big to fail revolves around the concept of systemic risk and as Pooran notes: ‘The issue of systemic risk goes to two fundamental issues: first, the interconnectedness of the global financial system; and second, the need for a tangible reflection in regulatory terms of the links between the financial sector and broader economy….A post-crisis trend resulting from the growth of systemic risk as a core supervisory element is the movement away from the reliance on regulation, in traditional terms, as a sufficient approach to governing financial markets, to recognition of risk in a broader sense as a more useful, modern-day barometer of the condition both of the individual components of the financial sector and, more importantly, of the broader links between the financial sector and the economic system at large.’

It is this notion of connectedness that is crucial to understanding the too big to fail debate. In Dorn’s view the enormous public bailouts prompted by the GFC should not so much be understood or described as TBTF (too big to fail), but rather TCTF (too connected to fail). Dorn warns that the TCTF/TBTF public bailouts eventually may turn out to be more destructive to economic systemic stability than letting financial institutions fail: ‘TCTF is not a “fact” but a political construction; that historically it developed within a particular national context, that of the US, notwithstanding which it influences policy minds globally; that bailouts are no better than bankruptcies when measured against yardsticks such as systemic stability, costs to the public finances and stability of (hitherto) sovereign states; and that moral hazard had been deepened for the coming years. TCTF beliefs, bailout expectations and systemic instability are mutually constitutive. A breakdown in the system does not result from failing firms, but from stopping them fail.’

The dilemma discussed by Dorn revolves around notions of abdication of moral hazard which describes contexts in which parties may take positions that may allow them to generate profits if the strategies are successful, but if the strategies fail and generate losses then the losses are borne by others. The origins of the term stem from the early days of the insurance industry and it has been a central tenet of not only insurance but commerce in general that moral hazard should be costed and priced into business activity. The abdication or massive diminution of moral hazard is seen by many as contrary to central tenets of competitive capitalism and the antithesis of Adam Smith’s invisible hand of the market. So the too big to fail emergency funding programs post GFC generated critical commentary which talked of privatising profits and socialising losses within financial capitalism and a rigged game in favour of the largest banks.

The G20 and other regulatory efforts regarding too big to fail

It has been in the context of this contested and contentious discourse that the G20 and various national and international regulatory actors have, over the last six years, launched a series of regulatory initiatives that have sought to manage the threats posed to systemic financial and broader economic systemic stability by very large and inter-connected financial institutions. At its Leaders Summit in Pittsburgh in 2009 as the global economy reeled under the pressures wrought by the GFC, the G20 asked the FSB to develop proposals to counter the systemic risks to the global economy posed by Systemically Important Financial Institutions (SIFIs). SIFIs have been defined by the FSB as: ‘..institutions of such size, market importance and interconnectedness that their distress or failure would cause significant dislocation in the financial system and adverse economic consequences. The “too-big-to-fail” (TBTF) problem arises when the threatened failure of a SIFI leaves public authorities with no option but to bail it out using public funds to avoid financial instability and economic damage. The knowledge that this can happen encourages SIFIs to take excessive risks and represents a large implicit public subsidy of private enterprise.’ The tensions engendered by this public subsidy: private enterprise dilemma were discussed above and they continue to percolate around evolving regulatory efforts in both national and international contexts.

Randell stresses that successful multi-lateral implementation of SIFI and TBTF reforms face ongoing challenges related to: differences in national regulatory regimes; complexity of SIFI structures; incentive structures within firms and their effects on market practice; disputes about appropriate levels of bail-in; and the financing of resolution regimes. Davies discusses the UK and US experience regarding the perennial national regulatory difference: coordinated global regulatory approach tensions when trying to build operational regulatory machinery to deal with SIFIs. He concludes: ‘Both the UK and the US can be seen to be hedging their bets about whether co-ordinated resolution will work by putting in place measures likely to make it more probable that group entities established within their jurisdictions will be able to survive periods of financial stress – irrespective of what happens to the group as a whole.’  O’Brien reminds us that inter-jurisdictional tensions such as these are an ongoing feature of financial regulation: ‘The global financial crisis has highlighted the problem of how to create effective resolution schemes for systemically important institutions. This is not a new phenomenon. Exactly the same considerations were at play when the first systemic attempt was made to regulate capital markets in the United States in the aftermath of Roosevelt’s election in 1932. Then the contours of the problem were defined by state–federal rather than intergovernmental relations.’

Prominent national and international regulatory actors remain aware that the structural problems associated with SIFIs remain. For example, Andrew Haldane, Chief Economist and Executive Director, Monetary Analysis & Statistics at the Bank of England: ‘Too big-to-fail is far from gone. It is even more important that it is not forgotten.’ Mr Haldane is undoubtedly correct but any regulatory initiatives, whether national or international, have to develop within hotly contested political environments in which there is still widespread suspicion about the size and risk profiles of many financial institutions. For example US Democratic Senator Elizabeth Warren, supported not only by her Democratic colleague Senator Maria Cantwell, but also by Republican Senator John McCain and Independent Senator Angus King, argues that: ‘..over five years after the crash, the big banks are more concentrated and more interconnected and their appetite for excessively risky behavior is unchanged. The biggest banks are substantially bigger than they were in 2008.’

Nevertheless, there has been positive progress on a number of fronts regarding too big to fail. For example in: assessment and designation; additional loss absorption; supervisory intensity; effective resolution; and strengthened core infrastructure. The FSB has reported that the G20 will continue to promote efforts to improve information sharing between jurisdictions, implement remaining elements of its existing reform agenda, increase legal certainty in cross-border resolution cases and promote international compliance with the key attributes of its effective resolution regimes for financial institutions. In its 27 October 2014 report on structural banking reform to G20 Leaders in preparation for the Brisbane Summit, the FSB reports on these developments and its cooperative relationship with key international actors such as the International Monetary Fund (IMF) and Organisation for Economic Cooperation and Development (OECD). A key strategic priority for all these bodies is: ‘..the importance of ongoing monitoring of market reactions (both domestically and offshore) during the implementation phase.’  So in terms of dealing with the problems associated with too big to fail financial institutions some of the regulatory dots have indeed been connected but much still remains to be done. It is to be hoped that more progress will indeed be made later this month in Brisbane at the G20 Leaders Summit.

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