There are two main types of lack of information, which occur in the financial system. They are adverse selection and moral hazard. Adverse selection is the problem which appears before the transaction. It means that people who intend to take on excessive risks seek out loans most actively and can be selected with high probability. That is why some lenders may decide not to make loans at all. Moral hazard is the problem which occurs after the transaction. This is the risk that the borrower after getting money will engage in activities which are very risky and which are undesirable for the investor.
Such problems may freeze the whole financial system and lead to the systemic risk. One of the possible reasons for the appearance of the moral hazard is the existence of a government safety net. This measure is created for saving banks and other financial institutions for preventing their failure. There are two main ways to handle the failed bank. The first is a payoff method. According to it the FDIC (Federal Deposit Insurance Corporation) allows the bank to fail and then pays off all deposits up to $100,000. After the liquidation of the bank the FDIC pays off its debts to other creditors from the liquidated assets.
Usually people who have deposits in excess of $100,000 limit get back more than 90 percent of their money, but the process may take several years. The second method is called the purchase and assumption method. The FDIC reorganizes the bank. Usually it is made by seeking a merger partner, who is willing to take over all deposits of the failed bank. In this situation no depositors loses his or her money. In addition, the FDIC provides the backstop for the merging bank – sometimes it buys weaker loans of the failed bank.
But, as I mentioned earlier, all these things may lead to the moral hazard. Such problem may be seen when looking at the issue of so-called “too big to fail” institutions. In this paper I am going to describe this issue and look at advantages and disadvantages of such institutions and the common method of regulation and its shortcomings. The term too big to fail refers to the banks, which are very large and interconnected. They also can be identified by the market concentration. They are so large that their failure may cause the calamity in the financial system.
They may freeze the whole economy, when all depositors will withdraw their money not only from this bank, but also from the others. That is why bank regulators are often reluctant to allow big banks to fail, because such situation will result in losses to the depositors. When the deal has to do with big banks the FDIC guarantees not only deposits up to $100,000 limit, but also other deposits that are larger. The bank may be classified as systemically important in two cases: * when it provides services which are significant to the whole economy; when other participants of the financial market cannot provide customers with necessary services within the required period of time. The source of too big to fail institutions should also be examined. There are three main reasons why policymakers engage into too big to fail policy. They are: 1. concerns about the fallouts caused by the failure of large institutions; 2. motivation by personal rewards; 3. desire for directing credit. The first reason is based on the policymakers’ willingness to act in the public interests.
They bail out large banks, because losses to the depositors may spill over to other banks and cause the systemic shock to the whole banking system, which will be very costly for the government. The second reason consists in personal gain for policymakers. Thereby bank may be identified as too personally important to fail. Interests of the regulator may differ from the interests of the public and the government may prop up big banks because officials will bear undesirable losses as the consequence of their failure. The third reason is the intention of the policymakers to direct credit.
Large banks are usually controlled by the government. This helps to attract customers through the influence of the government. In addition, through its own banks the government can lend money to whoever it wants. The first motivation is the most important in all economies and the third – in small economies, where the government is very active in controlling banking system. In large economies such as the US economy policymakers stay out of directing banks and the third reason is not dominant for the existence of the institutions of a large scale.
The typical too big to fail case occurred in 1984 when Continental Illinois National Banks faced a run owing to the rumors about bad loans. The FDIC foresaw the collapse of the Continental, which could provoke the breakup of the other smaller banks, whose funds it held, and of other big banks, which could face the withdrawals. That is why the government decided to provide Continental with money to prevent its failure. After that the Comptroller of the Currency ascertained that the eleven largest US banks were too big to fail. After that the measures for large banks were extended in the late 1980s.
The main problem of too big to fail banks policy is that it increases the intention of bankers of taking on excessive risks. As a result, they invest money in undesirable for depositors and very risky projects, they take on more risk than they can handle. As for the depositors, they will be sure that all their money won’t be lost, that is why they won’t be interested in monitoring the bank’s activities closely and in pulling their money out if the bank if it engages in risky deals. And banks are more likely to take on greater risk.
One of the possible ways to avoid such problems is to decrease the incentive of the government to bailout these institutions. That means that some policy measure should be created which reduce the existing costs to the whole financial system of their failure and mitigate spillover effects. In this situation depositors will worry about the activities of the bank and will monitor it. And in the case of excessive risk taking they will pull their funds from the bank. As a result these movements will reduce moral hazard. One more problem created by too large financial institutions is resource misallocation.
When bankers know that their bank will be saved by the government they are not likely to operate in a cost-efficient manner and, obviously, they are not interested in research and development. Such behavior stalls the technical progress. In addition, some banks grow in size, because they just want to get special subsidy, which is given to too big to fail banks. These banks can borrow money at a much lower cost than other banks, which can borrow funds according to their creditability. That is why the quantity of mergers goes up and the size of the institutions is much larger than it is needed and the optimal state can’t be achieved.
Stern and Feldman also argued that too big to fail bank often was some kind a trigger of many banking crises throughout the world. But more precisely we may state a reason for the crisis which is not too big to fail banks, but too politically important to fail. This statement is true for many emerging countries, where bankers are very powerful. But in these countries the government bails out almost all banks, so too big to fail banks didn’t play the dominant role in the crises. I would like to look at the role of too big to fail banks in the recent financial crisis.
During the crisis of 2007-2009 the US policy included substantial backstop to the large financial firms. The Federal Reserve created some new programs to inject funds into financial markets. The biggest financial institutions of the USA hold the largest part of assets and liabilities of the financial sector. In his speech “Causes of the recent financial and economic crisis” Ben S. Bernanke, the current Chairman of the Federal Reserve calls too big to fail financial institutions not only one of the sources of the recent crises, but also one of the impediments to policymakers’ efforts to contain it.
During the crisis large firms from AIG to Bank of America were given money to prevent their collapse. That is why although they seem to be very sound and stable, they remain fragile. As a result they cannot exist without government’s support. That happened in 2008, when the overall uncertainty in the economy about what would happen further and the failure of Lehman Brothers, which was extremely interconnected and which was one of the major players in different financial markets. This event caused markets to crash.
After that situation it became understandable that letting other firms fail would cause an enormous panic and adverse effects, which could lead to the calamity for the whole economy. Thereby it can be seen that the existence of too important to fail institutions is very dangerous not only for the country, where they are based, but also for the whole world because of their connection with international firms. To prevent problems listed above some measures should be taken. The regulation should be stricter, the financial standards for banks and other institutions are to be revised and become more rigorous.
First, restrictions for mergers, which lead to the institutions above limited size, may be implemented. The size of organizations may be measured by their assets, counterparty risk exposure, their indebtedness or by the combination of these factors. It is difficult to determine what size is the optimal for the economy, but to restrict all mergers will make the government bear larger costs. Second, it is possible to subject large institutions to tougher regulatory standards and scrutiny than their counterparts of smaller size.
Such standards include capital, risk-management and liquidity standards, which should be higher for too big to fail banks. They have to raise or take additional capital. But higher capital standards may stall growth above any particular point. That is why capital standards have to differentiate among assets by their risk and by the size of the financial institution. Moreover, systemically important institutions should be overseen and supervised by a single special regulator. This will eliminate the risk of regulatory duplication of efforts or inconsistent rules.
To draw a conclusion, I would like to outline that we need to have big financial institutions nowadays because they have to be of a large size to operate in the global capital markets. But their existence can lead to adverse effects for the whole economy. And the government realizes that the costs of allowing a failure overweigh the costs of avoiding the failure by any means. That is why the banks become very fragile and cannot remain sound and exist without the help of the policymakers. To prevent all these situations the regulators should review all existing standards and make them more rigorous.