Finance

Too Big To Fail

Too Big To Fail

Banks are becoming systemically important due to their scale, cross-jurisdictional operations, sophistication, and lack of alternatives and interconnections. The word ‘too big to fail’ became part of the mainstream culture amid the financial breakdown in the second half of 2008. It indeed denotes a double-sided threat, in which both excessive institutional size and the probability of loss are implied.

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Too Big to Fail Explained:

When a business or a business sector is so deeply entwined in a financial system or economy that its failure would in-turn be catastrophic to the economy, then such a situation is considered as ‘Too Big To Fail’. In the phrase, “Big” refers to the company’s involvement across multiple economies, rather than its size. The firms in need of rescue were financial firms that had relied on derivatives to gain a competitive advantage when the economy was booming. As the housing bubble crashed, their investments seemed to collapse. During these times a bailout is considered which means that the government injects capital by providing money and/ or resources to the failing business or even an entire sector- to prevent economic disaster. These firms had become so heavily involved in these derivatives that they had become too big to fail.

Example:

The most dramatic example of “Too Big To Fail” after the global financial crisis is the bailout of Wall Street banks and other financial institutions. Bear Stearns was the first bank that was too big to fail. It was a small but prominent investment bank that invested heavily in mortgage-backed securities. The Federal Reserve offered $30 billion for JPMorgan Chase & Co. as the mortgage securities market crashed to purchase the Bear Stearns, to mitigate concerns about the loss of trust in other banks. This was later followed by the collapse of Lehman Brothers, resulting in October 2008 Congress passed the Emergency Economic Stabilization Act (EESA). This included the $700 billion Troubled Asset Relief Program (TARP), which authorized the government to purchase distressed assets to stabilize the financial system. This meant that the government was bailing out banks for the greater good of the economy. 

AIG- How was it rescued?

Another example of Too Big To Fail is American International Group(AIG). They dealt with insurance products traditionally but when the company delved into credit default swaps, it began taking enormous risks. Those swaps insured mortgage securities owned by investors, which if AIG went bankrupt, would cause the collapse of the financial entities that purchased the swaps. Even if AIG had more than enough assets to fund the swaps, it did not sell them until the swaps had been due, leaving AIG without the cash to reimburse the swap insurance. The Federal Reserve provided a two-year loan of $85 billion to AIG to further reduce stress on the global economy. In return, the government received a whopping 79.9% of AIG’s equity and the right to replace management. The Fed bought $52.5 billion in mortgage-backed securities. These funds allowed AIG to retire its credit default swaps rationally, saving it and much of the financial industry from collapse and becoming one of the largest financial rescues in U.S. history.

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Reforms passed: 

Dodd-Frank Act:

Passed in 2010, Dodd-Frank was created to help avoid the need for any bailouts in the future financial system. The new regulations regarding capital requirements, proprietary trading, and consumer lending were added among its previous regulations. Dodd-Frank also imposed higher requirements for banks collectively labeled as Systemically Important Financial Institutions (SIFIs). The Volcker Rule, another part of Dodd-Frank, also helps limits the amount of risk large banks can take, hence coming too big to fail. It prohibits them from trading in stocks, commodities, or derivates that could reap profits for their company. They can do that only on behalf of their clients or to compensate for business risk.

Global Banking Reform:

The 2007-08 financial crisis affected banks tremendously around the world. Global regulators also implemented reforms, while focusing majorly on regulations for too-big-to-fail banks. These global bank regulations are primarily carried out by the Basel Committee on Banking Supervision, the Bank for International Settlements, and the Financial Stability Board.

 

Author: Mahek Medh

About the Author: Currently, I am in my second-year bachelor’s program and over the period of time I have realized that I enjoy learning about numbers and money, and I find topics of Finance to very interesting thus this is the domain and space where I wish to etch my long term career.

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