This is a financial and economic approach to corporations or industries that are deemed vital to the economy. The failure of these is viewed as presenting system risk that must be avoided. It is often applied to banks and other financial institutions although the transportation sector is often looked at the same way.
Too-big-to-fail gained popularity after the 2007-2008 financial crisis when the banks and financial system received trillions of dollars in bailouts. This led economists to opine changes that should be made.
Alan Greenspan, for Chair of the Fed, claimed too big to fail meant to big. He advocated breaking these firms up. Paul Krugman, on the other hand, pointed that under regulation was the problem and government should step up in that area.
The actual origin of the phrase dates back a couple decades. It was popularized by U.S. Congressman Stewart McKinney in a 1984 Congressional hearing, discussing the Federal Deposit Insurance Corporation's intervention with Continental Illinois.
Ben Bernanke
Ben Bernanke was the Chair of the Fed when the Great Financial Crisis hit. Due to his position, he had a lot of conversation about the concept of too-big-to-fail.
Here is how he defined it:
"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.
He also espoused:
"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. Common means of avoiding failure include facilitating a merger, providing credit, or injecting government capital, all of which protect at least some creditors who otherwise would have suffered losses. ... If the [subprime mortgage crisis] has a single lesson, it is that the too-big-to-fail problem must be solved."
Risks
According to Bernanke, there are a number of associated risk with too-big-to-fail companies.
- generate severe moral hazard
- uneven playing field between big and small
- these firms are a risk to overall financial stability, especially in light of an absence of resolution tools
During the lead up to the Great Financial Crisis, mortgage lenders were selling the debt to companies that were forming mortgage pools churning out mortgage backed securities (MBS). These assets were rated by Wall Street agencies as on par with U.S. Treasuries. For this reason, insurance companies, smaller banks, and pension funds were purchasing them. When these value of these was exposed, the balance sheets of these entities were negatively hit.
In the United States, many local and community banks were put out of business. The central bank had to take on the liabilities while the assets were sold to other banking institutions.
Possible Solutions
- Break up largest banks
- Increase regulation upon financial institutions
- Too-big-to-fail tax
- Monitoring
All of these require government intervention. Of course, the situation exists usually because of bailouts provided by these same entities.
The challenge with regulation and monitoring is that, over time, as the political players change, these tend to get rolled back. It is important to cite how the Glass–Steagall legislation put in place in the U.S. Banking Act of 1933 was removed by the Gramm–Leach–Bliley Act in 1999.
Many believe this led to much of the crisis that ensued almost a decade later.