The latest issue of the IMF’s Global Financial Stability report (GSFR, March 2014) provides a comprehensive analysis of the “too important to fail” (TITF) problem.
The TITF problem is a well-known one in banking literature, and it arises from the fact that in an interconnected financial world, the failure of a major financial institution can have severe negative macroeconomic and macrofinancial impacts on both a national and global basis, therefore forcing governments to intervene to prevent a financial collapse. The two decades preceding the 2008 financial crisis witnessed an unprecedented period of financial globalization. Cross-border bank claims (as reported by the Bank for International Settlements, BIS) had increased to about 50% of global GDP by 2007. Moreover, the financial globalization was accompanied by an increasingly complex web of interconnectedness among major financial institutions in about 20 core countries, which accounted for 95% of the total cross-border claims.
The TITF problem has become more prominent since the financial crisis of 2008, as the financial system has become more concentrated (often as the result of government pressures for healthier financial firms to take over weaker ones). As a result of this rising concentration, the top three banks in most of the core countries account for at least 40% of total assets.
The largest banks in each country are classified as SIFIs (systemically important financial institutions) by regulators in the United States and SIBs, or G-SIBs (globally systemically important banks) by the Basel committee. No matter how they are called, these institutions are the focus of TITF.
Many academics and financial analysts have argued that the fact that large banks are TITF gives these institutions a funding advantage, since depositors and investors are going to assume that the governments (and ultimately the taxpayers) will have no choice than to bail out the bans in the case of severe financial distress. The GFSR study is the first major compilation of the results of a number of studies and methodologies to estimate the implicit funding subsidy. The GFSR identified three methodologies: (i) bond ratings; (ii) contingent claims analysis; and (iii) credit ratings. Based on these methodologies, the GFSR estimated the implicit subsidies to banks as follows: 15 basis points (bp) for the United States, 25-60 bp for Japan, 20-60 bp for the UK and 60-90 bp for the eurozone—in dollar terms, worth tens of billions of dollars.
Since the financial crisis, the major governments and international regulators like the Basel Committee have attempted to deal with the issue of TITF in the context of financial regulation reform (Dodd-Frank in the United States, the Vickers report in the UK, and various proposals under discussion at both the eurozone and European Union levels). Basically, policymakers and regulators have attempted to integrate four policy options in the new rules: (i) restrict bank size and activities; (ii) reduce the probability that a SIB becomes distressed; (iii) lower the probability of an SIB bail-out; and, (iv) minimize public transfers in the event of a bail-out. Reforms like the Volcker rule and ring-fencing are designed to restrict bank activities and ultimately prod them into divestment of certain high risk activities. Higher capital and liquidity rules, enhanced supervisory vigilance and increased transparency, in particular for the SIBs and SIFIs, also increase the loss-absorbing capacity and resilience of the larger players—these are built-in in both Dodd-Frank and Basel-III. Bail-ins, participation in resolution funds by the major banks and explicit resolution authorities (or living wills) for the banks also reduce the potential financial burden on the taxpayers. Most importantly, removing the perception of an eventual government bailout will at the very least reduce the TITF subsidy enjoyed by the largest banks, leading to a more market –driven approach to funding and reducing systemic risks.
Furthermore, there is a need for international regulatory coordination to prevent regulatory arbitrage and also avoid mutually destructive policies. There is no magic bullet for the TITF problem, and in the words of Ben Bernanke, the former Fed chairman, the TITF problem is neither solved nor gone. However, the regulatory reforms in place are a credible effort to alleviate the problem and reduce the both the risks and costs of another financial crisis.
Karim Pakravan has been a Visiting Associate Professor of Finance at DePaul University since 2008. Prior to that, Pakravan had a 25-year career in global banking and finance. Since rejoining academia, Pakravan had lectured extensively on money and banking, financial management, international finance, and quantitative methods in finance. He has also been teaching a case-based private equity class since 2011. Pakravan’s research has focused on global macro-financial markets and regulation, topics in which he has published two papers since his return to academia. His research in the field is on-going, and he has also maintaining a continued interest in geopolitical issues. Pakravan holds a PhD in Economics from the University of Chicago.
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