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Friday, July 5, 2013

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 highlighted 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, and they can be TBTF because of their size or interconnectedness. In addition to fairness issues, economic theory suggests that expectations that a firm will not be allowed to fail creates moral hazard—if the creditors and counterparties of a TBTF firm believe that the government will protect them from losses, they have less incentive to monitor the firm’s riskiness because they are shielded from the negative consequences of those risks.

Legislation to address the TBTF issue include S. 798, S.Amt. 689 to S.Con.Res. 8, S. 100, H.R. 1485, H.R. 1450/S. 685, and H.R. 613. There are a number of policy approaches—some complementary, some conflicting—to coping with the TBTF problem, including

  • 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; and 
  • instituting a special resolution regime for failing systemically important firms. 

A comprehensive policy is likely to incorporate more than one approach, because some approaches are aimed at preventing failures and some at containing fallout when a failure occurs.

Parts of the Wall Street Reform and Consumer Protection Act (Dodd-Frank Act; P.L. 111-203) include all of these policy approaches. For example, the Dodd-Frank Act created a special enhanced prudential regulatory regime for financial firms identified as “systemically important” by the Financial Stability Oversight Council and bank holding companies with over $50 billion in assets. The Federal Reserve will administer this regulatory regime, which includes higher capital and liquidity standards. 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. Statutory authority used to prevent financial firms from failing during the crisis has either expired or been narrowed by the Dodd-Frank Act.

To date, the major changes in the Dodd-Frank Act remain in the implementation phase, making it premature to judge what effect it has had on the TBTF problem. The U.S. Financial Stability Oversight Council has reportedly designated three non-banks as “systemically important,” and therefore subject to heightened prudential regulation. However, the Financial Stability Board, an international forum, has identified 28 financial firms as “systemically important financial institutions,” 8 of which are headquartered in the United States. These firms will be assessed capital surcharges under Basel III.

Date of Report: June 19, 2013
Number of Pages: 56
Order Number: R42150
Price: $29.95

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