The Too-Big-To-Fail Problem

The too-big-to-fail problem refers to the issues that arise when a large bank is so pivotal and engrained in the financial system, that its failure would be detrimental to the economy as a whole. But how has this problem come about? And what can realistically be done to combat this ever-present issue? This article will attempt to answer these questions as well as exploring the government bailout of RBS as evidence of the problem.

What Is It?

As previously mentioned, the too-big-to-fail problem comes down to the systematic importance of large banks, and how the failure of one of these banks could cause major damage to both the financial system and the wider economy. The gargantuan costs associated with the failing of a large bank or financial institution motivate policy actions in order to prevent the failure. Although the cost of ‘bailing out’ (using public funds to avoid failure) a bank can be enormous, the effects of a bank failure are argued to be much more costly. The general consensus is that large banks failing can lead to contagion effects. This is where troubles that affect one bank may be transmitted to another bank through the interbank market, leading to a deterioration in the financial system. Commercial banks may also suffer the consequences of bank runs, where depositors look to withdraw cash due to a lack of confidence, leading to liquidity shortages. Some would argue that these effects should be avoided at all costs, giving rise to the idea that large banks are too-big-to-fail.

What Is the Problem?

The problem with having banks that are viewed as too-big-to-fail is the creation of moral hazard. This is the economic idea that an individual or entity does not have to bear the costs of their actions. For too-big-to-fail banks, because the government or regulatory body will not allow them to fail, these banks have an incentive to take on more risk. The benefit of this is the potential for greater returns on investments. However, in the event that taking on more risk backfires, the resulting extreme losses can be destructive for the government and the economy, who would have to pay for the bank’s mistakes. In this way, the assumed protection of too-big-to-fail banks at the expense of the government may actually lead to financial instability in the long term.

How Has It Come About?

The term ‘too-big-to-fail’ was first coined during the failure of Continental Illinois (a US commercial bank) in 1984. The bank’s extensive relationships with both retail and corporate clients meant that a bailout was almost inevitable once the bank had found itself in financial difficulty. [1] This pushed the too-big-to-fail problem to the forefront of the financial regulatory debate. Since then, greater availability of credit in the 1990s and increased diversity of services offered have enabled tens of banks to grow in size and be considered too-big-to-fail. [2] The difficulties in solving this problem have also furthered the extent of the issue, as a lack of effective action means the problem worsens as time goes on.

How Do We Measure It?

The size of a bank is the general characteristic used when determining whether or not it is considered too-big-to-fail. Although there is no universal threshold, legislation in the US gives a strong insight into whether or not a bank or financial institution should be considered in this way. The infamous 2010 Dodd-Frank Act characterised a systematically important financial institution as one with $50bn or more in assets. At the time of introduction, this meant that 38 banks operating in the US were indirectly thought of as too-big-to-fail, although this threshold has since increased. [3] Thus, it is clear that there are numerous banks that, in the event of failure, could wreak havoc for the financial markets. Despite being a useful indicator, it could be argued that it is not just overall size that should be taken into account. Though difficult to measure, the influence that a bank has should also be considered, especially when some institutions are more heavily intertwined in the commercial banking sector.

RBS – A Case Study

The UK government bailout of RBS in October 2008 is a pristine example of a bank being too-big-to-fail. For a short period, RBS was the biggest bank in the world by assets. [4] Thus, it can be understood why the government thought it necessary for the bank to be bailed out when it found itself in financial trouble. The reasons behind this financial trouble really highlight the assumed nonchalant attitude of too-big-to-fail banks. Although there are a plethora of reasons for RBS’s failure, the bank's huge overall exposure to risk emphasises the moral hazard at the time. Arguably, it could be said that the need for a government bailout came as a consequence of this moral hazard, created from the bank being too-big-to-fail. The case study of the failure of RBS is not only an excellent example of how the actions of too-big-to-fail banks lead to their failure, but also how the government reacts to their failure.

What Are the Potential Solutions?

With a contentious topic like the too-big-to-fail problem, there is much debate about what can be done to solve the issue (if there is anything at all). One of the first solutions to come to mind may be to put a cap on bank size. However, this does not come without its issues. Choosing the level at which the cap should be would be a near-impossible task and would cause a whirlwind of debate amongst some of the banks near the proposed cap. Another issue with a size cap is that banks may have to narrow the range of services that they offer to meet the new requirements. This could be an issue to the bank's customers as well as the bank itself, who could experience hardship as a result of decreasing revenue streams.
An alternate remedy to the too-big-to-fail problem may be to enhance the financial regulation of large banks. This may reduce the risk appetite that a bank chooses and potentially decrease the risk of failure. An integral point about regulation though is the cost of it. With the estimated cost of regulation in the UK at around £1.9bn, there is little scope to increase this figure, especially when considering the strain that the COVID-19 pandemic has had on public finances. [5]
Evidently, it is clear that the popular solutions to this ever-growing problem are not without their limitations.

To summarise, the too-big-to-fail problem is only going to grow as banks get larger, and little to nothing is done to remedy the situation. The issues in measuring whether or not a bank is characterised in this way, as well as the problems involved in regulating banks that are already ingrained in the financial system, put substantial limitations on ideas that could solve the overall problem. In the long term, it will be interesting to see how financial regulation is curated to chip away at the too-big-to-fail problem.