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What is 'Too Big To Fail'?

"Too big to fail" describes the concept whereby a business has become so large that a government will provide assistance to prevent its failure because not doing so would have a disastrous ripple effect throughout the economy. If a large company fails, companies that rely on it for portions of their income might also be extinguished along with the employment they provide. Therefore, if the cost of a bailout is less than the cost of the failure to the economy, a government may decide a bailout is the most cost-effective solution.

BREAKING DOWN 'Too Big To Fail'

“Too big to fail” is the idea that specific businesses, such as the biggest banks, are so vital to the U.S. economy that it would be disastrous if they went bankrupt. To avoid a crisis, the government might provide bailouts to protect creditors against losses and enable managers to retain their high wages and bonuses. This concept was integral to the financial crisis of the late 2000s when the U.S. government disbursed $700 billion to save companies, such as AIG, that were on the verge of financial failure.

Background on Bank Reform

Because of bank failures during the Great Depression, deposit insurance and regulators, such as the Federal Deposit Insurance Corporation (FDIC), were created to take over and efficiently liquidate failing banks. In 2007 and 2008, deeply indebted investment banks without FDIC protection faced failure as creditors and shareholders doubted their solvency. When Lehman Brothers collapsed, regulators discovered the biggest firms were so interconnected that only large bailouts would prevent half the financial sector from failing.

Dodd-Frank Act

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 was created to avoid future bailouts. Part of the Act requires financial institutions to create living wills outlining how they will liquidate assets quickly if filing for bankruptcy. In November 2015, an international board of financial regulators published rules requiring big banks to raise up to $1.2 trillion in new debt funding that can be written off or converted to equity in case of losses.

Debate over Solvency Solutions

According to a 2014 study by the International Monetary Fund (IMF), many lenders who believe governments will not let big banks go under produce annual savings up to $300 billion. The savings suggest that an implicit subsidy could be at least as big as the big banks’ profits, and governments should charge accordingly for the subsidy. In emerging markets such as China, the government owns the biggest banks, which means it enjoys the upside in good times and shoulders the burden when banks need bailouts. However, a July 2014 study by the Government Accountability Office (GAO) showed that any borrowing advantage has dramatically shrunk, making such a solution infeasible for the United States.

In December 2015, Standard and Poor’s downgraded U.S. big banks’ debt rating stating that new capital requirements could make bailouts less likely. Ultimately, global banks operate across borders, and no agreement exists among national authorities regarding response to a financial crisis. Countries have different laws, asset protection procedures and court systems. Immediate prospects for an international treaty are nonexistent.

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