'Too-Big-To-Fail' Question Must Be Solved

by Glen Shapiro, LawAndTax-News.com, New York

07 September 2010

In testimony to the United States’ Financial Crisis Inquiry Commission, the Chairman of the Board of Governors of the Federal Reserve System, Ben Bernanke, said that, above all, the problem of ‘too-big-to-fail’ banks had to be resolved by government policy.

While providing an overview of the factors underlying the crisis, as well as some of the problems that complicated management of the crisis by financial authorities, he considered that “too-big-to-fail financial institutions were both a source of the crisis and among the primary impediments to policymakers' efforts to contain it”.

He said that many of the vulnerabilities that amplified the crisis, including the banks’ dependence on short-term funding and deficiencies in risk management, and the gaps in the statutory framework of financial regulation, were linked with the problem of so-called too-big-to-fail firms.

He classified a too-big-to-fail firm as “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. Governments provide support to too-big-to-fail firms in a crisis not out of particular concern for the management, owners, or creditors of the firm, but because they recognize the consequences for the economy of allowing a disorderly failure.”

He pointed out that, “in the midst of the crisis, providing support to a too-big-to-fail firm usually represents the best of bad alternatives; without such support there could be substantial damage to the economy. However, the existence of too-big-to-fail firms creates several problems in the long run.”

Firstly, he continued, “too-big-to-fail firms will tend to take more risk than desirable, in the expectation that they will receive assistance if their bets go bad. The build-up of risk in too-big-to-fail firms increases the possibility of a financial crisis and worsens the crisis when it occurs. There is little doubt that excessive risk-taking by too-big-to-fail firms significantly contributed to the crisis, with Fannie Mae and Freddie Mac being prominent examples.”

“A second cost of too-big-to-fail,” he said, “is that it creates an uneven playing field between big and small firms. This unfair competition, together with the incentive to grow that too-big-to-fail provides, increases risk and artificially raises the market share of too-big-to-fail firms, to the detriment of economic efficiency as well as financial stability.”

“Third, as we saw in 2008 and 2009, too-big-to-fail firms can themselves become major risks to overall financial stability, particularly in the absence of adequate resolution tools,” he added. “The failure of Lehman Brothers and the near-failure of several other large, complex firms significantly worsened the crisis and the recession.”

He therefore concluded that, “if the crisis has a single lesson, it is that the too-big-to-fail problem must be solved. Simple declarations that the government will not assist firms in the future, or restrictions that make providing assistance more difficult, will not be credible on their own.”

He was pleased, however, to report that the new US financial reform law and current negotiations on new Basel capital and liquidity regulations have together set into motion a strategy to address too-big-to-fail.

The propensity for excessive risk-taking, he said, “must be greatly reduced, by more-rigorous capital and liquidity requirements, including higher standards for systemically critical firms, and tougher regulation and supervision of the largest firms”, while “a resolution regime is being implemented that allows the government to resolve a distressed, systemically important financial firm in a fashion that avoids disorderly liquidation while imposing losses on creditors and shareholders.”

He concluded that “prudential regulators should take actions to reduce systemic risks. Examples also include requiring firms to have less-complex corporate structures that make effective resolution of a failing firm easier, and requiring clearing and settlement procedures that reduce vulnerable interconnections among firms.”

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