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Tuesday, January 24, 2012

Systemically Important or “Too Big to Fail” Financial Institutions

Marc Labonte
Specialist in Macroeconomic Policy

Although “too big to fail” (TBTF) has been a perennial policy issue, it was brought to the forefront by the near-collapse of several large financial firms in 2008. Financial firms are said to be TBTF when policymakers judge that their failure would cause unacceptable disruptions to the overall financial system. Financial firms can be TBTF because of their size or interconnectedness. In addition to fairness issues raised by preventing a TBTF firm from failing, economic theory suggests that TBTF causes a moral hazard problem. Moral hazard refers to the fact that if TBTF firms know that failure will be prevented, they have an incentive to take greater risks than they otherwise would because they are shielded from the negative consequences of those risks. Specific assistance to TBTF firms, in contrast to broadly based programs, has proven to be the most costly intervention that the government undertook in the crisis.

There are a number of policy approaches—some complementary, some conflicting—to coping with the TBTF problem. These include 

         providing government assistance to prevent TBTF firms from failing or systemic risk from spreading; 
         enforcing “market discipline” to ensure that investors, creditors, and counterparties curb excessive risk-taking at TBTF firms; 
         enhanced regulation to hold TBTF firms to stricter prudential standards than other financial firms; 
         curbing firms’ size and scope, by preventing mergers or compelling firms to divest assets, for example; 
         minimizing spillover effects by limiting counterparty exposure; 
         instituting a special resolution regime, in the event of the failure of a systemically important firm, that would be administrative rather than judicial. 
A comprehensive policy is likely to incorporate more than one approach since some approaches are aimed at preventing TBTF, and some at containing fallout when a TBTF firm has failed.

Parts of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act, P.L. 111-203) address all of these policy approaches. For example, the Dodd-Frank Act created a special enhanced prudential regulatory regime for financial firms identified as “systemically significant” by the Financial Stability Oversight Council and bank holding companies with over $50 billion in assets. The Federal Reserve will administer this regulatory regime. Depending on which firms are identified as systemically significant, this could result in certain non-bank financial firms being federally regulated for safety and soundness for the first time. The Dodd- Frank Act also created a special resolution regime administered by the Federal Deposit Insurance Corporation to take into receivership failing firms that pose a threat to financial stability. This regime is similar to how the FDIC resolves failing banks, but with some important differences.

The major changes in the Dodd-Frank Act remain in the implementation phase. The U.S. Financial Stability Oversight Council has not yet identified any firm as “systemically significant,” and therefore subject to heightened prudential regulation. The Financial Stability Board, an international forum, identified 29 financial firms as “systemically important financial institutions” in November 2011. Eight of the 29 firms are headquartered in the United States.

Date of Report: January
13, 2012
Number of Pages:
Order Number: R4
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