EconSouth (First Quarter 2005)
When Is “Big”
Many financial market participants believe that if one of the largest banks in the United States became distressed, that bank would receive special government support, an expectation rooted in the belief that some banks are considered “too big to fail.” This characteristic distinguishes them from smaller banks, which some critics claim are treated as “too small to save.”
In Too Big to Fail: The Hazards of Bank Bailouts (Washington, D.C.: The Brookings Institution, 2004), Gary H. Stern and Ron J. Feldman, respectively the president and a vice president of the Federal Reserve Bank of Minneapolis, contend that policymakers’ actions have fostered the perception that some banks are too big to fail. Arguing that this perception imposes large opportunity costs on the economy, the authors recommend a series of specific steps to substantially reduce both the actual and perceived probabilities that a bank would be treated as too big to fail.
As the authors acknowledge, the title of the book is a bit of a misnomer arising from the language used by the press and in congressional hearings after Continental Illinois National Bank and Trust received government support in 1984. But no bank is literally too big to fail. Even the largest banks may go into receivership; management can be fired, shareholders can lose their claim, and creditors can lose. What “too big to fail” means is that the continued operation of the largest and most important banks is so important that their liquidation is not an option. More importantly, it also means that most of the creditors of these largest banks likely would be bailed out by the Federal Deposit Insurance Corp. to facilitate the continued normal operations of financial markets and to discourage deposit runs at other banks.
Often, the focus of concern on too-big-to-fail policies is on the bailout itself—both the cost to taxpayers and the perceived unfairness of the government selectively bailing out large creditors of large depositories. Stern and Feldman, however, argue that the most important costs of large banks’ receiving bailouts are occurring now and not at some indefinite point in the future. When investors perceive that creditors at certain banks face little risk of loss, investors might be induced to provide funds on terms that do not fully reflect the risk levels of the banks. As a consequence, the price signals banks receive encourage them to become larger and invest in riskier assets than they otherwise would. These expanded banks are less efficient than they would be absent the perception of being too big to fail, and society’s investment in real assets is more risky than is socially optimal.
Stern and Feldman argue that, in order to change market expectations that a large bank would be bailed out, policymakers must make a credible commitment to impose losses on creditors. Merely announcing that henceforth large-bank creditors will not be bailed out is not credible. Without other changes, the failure of a large bank without a bailout would allow market participants to conclude that large, adverse spillovers to other institutions and to financial markets could occur.
The book suggests a variety of measures that would reduce the perception that a bank would be treated as too big to fail. The first step, the authors say, is simply to recognize that the problem exists and provide for ongoing recognition of the expected costs in government budgets. Such recognition would give policymakers a continuing incentive to reduce the costs of failure.
The remainder of Stern and Feldman’s recommendations consists of reforms intended to reduce both the perceived and actual threats that a large bank’s failure poses to other banks, the financial sector, and the overall economy. The authors propose that supervisors plan for the failure of a large bank. Such planning would help supervisors prepare for more troubling scenarios. Other proposed reforms would reduce creditor risk by strengthening existing policies on timely resolution, clarifying the treatment of different creditor classes if a bank goes into resolution, and providing liquidity more rapidly to uninsured creditors.
Stern and Feldman’s book is a timely statement on an important topic. Now is the time to address the costs associated with the perception and reality of too big to fail. Bank supervisory policymakers should focus on this concept because the largest economic costs associated with it are occurring now. Moreover, by acting now, policymakers have a variety of options for dealing with its consequences. If no action is taken until a large bank becomes distressed, policymakers may have little choice but to make the perception that some banks are too big to fail a reality.