Too Big To Fail Meaning History Banks How To Prevent

Too Big To Fail Meaning

Knowing how a financial system would ordinarily operate in an economic downturn helps regulators and markets determine if a given business fits the TBTF definition. Governments identify these systemically important financial institutions (SIFI) based on the potential impact of their failure on other entities. The U.S. government rescued many banks and insurance firms during the global financial crisisFinancial CrisisThe term “financial crisis” refers to a situation in which the market’s key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more of 2007-2008 to prevent the economic collapseEconomic CollapseAn economic collapse refers to a severe contraction in the economy led by an extraordinary event (financial or structural) which is not a part of the normal economic cycle. It may lead to a decline in national growth, a rise in unemployment, and sometimes social unrest; therefore, it requires government or monetary authorities intervention.read more.

Key Takeaways

Too big to fail is a term that describes banking and financial institutions with a significant economic influence on the international financial system, and the failure of which could adversely affect the global economy.When these inter-connected banks and institutions begin to fall apart, governments come out to their rescue either via bailout or federal loans.Failure of these Systemically Important Banks or Financial Institutions might have a significant impact on other businesses.Bank of the Commonwealth, Bear Stearns, Lehman Brothers, Fannie MaeFannie MaeFannie Mae, i.e., Federal National Mortgage Association is a United States government-sponsored enterprise (GSE) which was founded in the year 1938 by congress to boost the secondary mortgage market during the great depression which involves financing for the mortgage lenders thereby providing access to affordable mortgage financing in all the markets at all times.read more, and Freddie Mac are some of the most well-known TBTF cases.

History

In the United States, the number of banks in the 1920s was around 30,000, which came down to 15,000 by the 1970s and 1980s. The saturation in the number of banks and financial institutions in the U.S. came following the dissolution of a non-competitive banking sector.

In the 1980s, Texas, which depended mainly on oil for its economy, suffered a massive financial crisis because of declining oil prices. Almost 100 banks collapsed because of the loss incurred.

How Did Banks Become Too Big to Fail?

Initially, the nation did not allow banks to compete with each other. Some states advocated for one bank in each state. Whereas a few states ruled to have only one bank branch in every state. These laws were a result of lobbying by operating banks to avoid competition.

As a result, banks became the representative of the local economy. And when the local economy would fail, the financial setup of that state would be disastrously affected.

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It was when the federal government intervened and allowed interstate banking. It eventually led to one bank buying the other and operating in more than one state. They also began to compete with one another, resulting in better products for consumers.

All of this resulted in a concentration of banks, with the biggest ones becoming too big to fail banks. Today, there are approximately 5,000 banks in the United States.

The Failures & Rescues

#1 – Bank of the Commonwealth

The first bailoutBailoutA bailout refers to the prolonged financial support offered by the government or other financially stable organization to a business in the form of equity, cash, or loan to help it overcome certain losses and stay afloat in the market.read more of a TBTF bank occurred in 1972 when Detroit-based Bank of the Commonwealth was on the verge of collapsing. In 1964, entrepreneur Donald Parsons acquired this medium-sized bank having $540 million in assets, and started investing a lot in municipal securities. While its municipal securities holdings grew significantly from 1964 to 1969, the rise in interest rates in 1969 caused the value of those assets to fall. In its effort to re-establish itself, the bank underwent a lot of debt in 1970.

Seeing the condition of the Bank of the Commonwealth, the Federal Deposit Insurance Corporation or FDIC feared the dissolution of it as an entity if any of the three largest banks in the city acquired it. Considering the bank’s role in the U.S. banking system and its valuable contribution to the commercial bank competition in Detroit, the FDIC lent $60 million to the bank to stand up again. But even after the extension of the loan, the bank could not recover completely and was later acquired in 1983 by Comerica Bank.

#2 – Lehman Brothers

The most recent TBTF case is of Lehman Brothers during the 2007-2008 global financial crisis. It became a lesson for those who believed that financial marketsFinancial MarketsThe term “financial market” refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.read more had some control over the U.S. regulators. Its dissolution seemed necessary to prove that lending to drowning systematically important financial institutions is not always possible. The investment bank filed for bankruptcy when Hank Paulson, the U.S. Treasury Secretary, disapproved its bailout.

Several other systemically important banks, including New Century Financial, American Home Mortgage, and Countrywide Financial, failed around the same time. Of these, Bank of America acquired Countrywide Financial in January 2008.

#3 – Bear Stearns

Bear Sterns, with mortgage-backed securitiesMortgage-backed SecuritiesA mortgage-backed security (MBS) is a financial instrument backed by collateral in the form of a bundle of mortgage loans. The investors are benefitted from periodic payment encompassing a specific percentage of interest and principle. However, they also face several risks like default and prepayment risks.read more in its portfolio, was the first bank designated as TBTF. During the financial crises, the collapse of the mortgage securities market forced the U.S. Federal Reserve to come up with a rescue plan. The central banking system offered a federal loan of $30 billion to JPMorgan Chase & Co. to acquire Bear Stearns to restore consumer confidence in systemically important banks.

#4 – Fannie Mae And Freddie Mac

In 2009, the two federal mortgage agencies announced a plan to guarantee 90% of all new house mortgages. As part of their plan, they started offering subprime loansSubprime LoansSubprime loans are given to entities and individuals by the bank, usually on a rate of interest much higher than the market, which has a significant amount of risk involved regarding its repayment in the specified amount of time.read more to even those incapable of paying them back. The agencies then sold these loans as financial instrumentsFinancial InstrumentsFinancial instruments are certain contracts or documents that act as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability to another organization and are solely taken into use for trading purposes.read more, allowing investors to generate higher returns following the housing bubble burst.

It was when the rising cases of mortgage defaults have increased the risk of both agencies going bankrupt. Given its potentially devastating impact on the housing market, the U.S. Treasury lent the financial support of $100 billion to pay all their mortgages. However, these agencies had to transfer their ownership to the Treasury in return.

Examples

Example #1

Imagine two categories of financial institutions that run a nation. Category 1 consists of five systemically important banks, each with a 10% market shareMarket ShareMarket share determines the company’s contribution in percentage to the total revenue generated within an industry or market in a certain period. It depicts the company’s market position when compared to that of its competitors.read more. But Category 2, which is supported by Category 1, consists of 50 banks, each with a 1% market share.

So, if one or two Category 2 banks fail, the nation’s economy will remain unaffected. However, if even one of the banks in Category 1 goes bankrupt, the impact on the financial market would be severe.

In short, the institutions in Category 1 are “TBTF” as their destruction would lead to devastating effects on the nation’s financial status.

Example #2

East India Company was not a financial institution but one of the largest organizations on earth. The British company had its army, navy, and coinage system. In short, it was en route to becoming equal to the government in all respect.

The too big to fail company funded the military conquests in India, which affected its finances adversely and put it under a lot of debt. As a result, the British government decided on a “mega-bailout” for the organization.

In 1773, the British Parliament passed the Tea Act and used the tea tax as a bailout policy to pay off the debt. The company sold its tea to the colonies in the U.S. at a tax rate lower than what the local tea merchants pay.

How To Prevent Banks From Becoming Too Big To Fail?

Several efforts have been made in the past to prevent systemically important banks from becoming TBTF. For example, establishing the Financial Stability Oversight Council and introducing the Volcker Rule under the Dodd-Frank Wall Street Reform Act of 2010. The U.S. government ensured that banks increase their reserve requirementsReserve RequirementsReserve Requirement is the minimum liquid cash amount in a proportion of its total deposit that is required to be kept either in the bank or deposited in the central bank, in such a way that the bank cannot access it for any business or economic activity.read more and take minimum risks. Apart from operations and crisis management, banks can avoid becoming TBTF in the following ways:

Enhance the value of the share capitalShare CapitalShare capital refers to the funds raised by an organization by issuing the company’s initial public offerings, common shares or preference stocks to the public. It appears as the owner’s or shareholders’ equity on the corporate balance sheet’s liability side.read more to exceed international standards, commonly known as Swiss Finish. It aids in the prevention of huge losses.Use contingent convertibles (CoCos) bonds that convert into shares in certain conditions. These act as big reserve tanks for banks when they find themselves in financial trouble.The Financial Stability Board (FSB) has introduced global financial system reforms under which the big international banks, including Goldman Sachs, Deutsche Bank, etc., should consider issuing special debt, which they could retain during the challenging market conditions.