Too Big To Fail: A Comprehensive Overview

An in-depth examination of the concept 'Too Big To Fail,' exploring its implications, historical significance, and relevant concepts such as systemic risk and moral hazard.

Definition

“Too Big To Fail” (TBTF) refers to organizations, primarily financial institutions, whose failure could trigger widespread economic instability due to their size, complexity, and interconnectivity with the global financial system. The collapse of such entities poses a systemic risk to the economic framework, compelling governments to intervene and prevent their failure.

Historical Context

The term gained significant prominence during the 2008-2009 financial crisis. It was widely used to describe institutions like American International Group (AIG), Lehman Brothers, and other banking giants. The government’s decision to bail out entities such as General Motors and Chrysler, despite them not posing systemic risks, broadened the application of the phrase to include job preservation.

Implications of “Too Big To Fail”

Systemic Risk

Systemic risk refers to the potential collapse of an entire financial system or market, as opposed to the failure of individual entities. TBTF institutions are intricately linked to numerous economic activities and other financial entities, so their failure could lead to a domino effect of financial disruptions.

Moral Hazard

Moral hazard occurs when entities or individuals are encouraged to take greater risks because they are protected from the consequences. The TBTF designation often leads to reckless financial behaviors as institutions expect governmental bailouts during financial distress.

Case Studies

2008 Financial Crisis

The 2008 financial crisis serves as a critical example of the TBTF phenomenon. Institutions like Bear Stearns, Lehman Brothers, and others were either bailed out or allowed to fail, causing significant turmoil. The U.S. government intervened to stabilize the economy, reinforcing the TBTF principle.

General Motors and Chrysler

In 2009, General Motors and Chrysler received governmental assistance to prevent massive job losses. While this situation didn’t pose systemic risks, it highlighted TBTF’s broader usage to safeguard economic stability.

Related Concepts

Bailout

A bailout is an act of giving financial assistance to a failing business or economy to save it from collapse. Bailouts can be aimed at stabilizing TBTF institutions to prevent systemic risk.

Dodd-Frank Act

Enacted in response to the 2008 financial crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act includes provisions aimed at reducing systemic risk in the financial sector and preventing the need for future bailouts.

FAQs

What criteria define an institution as 'Too Big To Fail'?

Various factors, including size, complexity, market interconnectedness, and the potential impact of failure on the economy, are considered in determining TBTF status.

Can the TBTF issue be resolved?

While regulatory measures such as the Dodd-Frank Act aim to mitigate risks, completely eliminating TBTF is challenging due to the inherent complexities of global financial systems.

Summary

“Too Big To Fail” underscores the criticality of certain financial institutions whose collapse could threaten broader economic stability. Originating during the 2008 financial crisis, TBTF highlights systemic risk and moral hazard issues, emphasizing the need for regulatory vigilance to prevent future crises.

References

1. “Too Big to Fail: The Hazards of Bank Bailouts,” by Gary Stern and Ron Feldman.
2. Dodd-Frank Wall Street Reform and Consumer Protection Act, U.S. Congress.
3. “The Financial Crisis Inquiry Report,” National Commission on the Causes of the Financial and Economic Crisis in the United States.