"Too big to fail" theory
The "Too Big to Fail" theory is an economic concept that suggests certain banks and financial institutions are so integral to the economy that their failure would lead to widespread financial devastation. This theory gained prominence during the Great Recession of the late 2000s, but its roots can be traced back to earlier economic crises, such as the Panic of 1907 and the Great Depression. To mitigate the risks associated with these large institutions collapsing, governments often implement protective measures, which aim to prevent financial catastrophe.
However, these interventions can create significant challenges, including fostering a sense of moral hazard, where large institutions may engage in risky behavior, knowing they are likely to receive government support if they falter. This dynamic can undermine competition, disadvantaging smaller banks that do not benefit from the same safety nets. The 2008 financial crisis exemplified the consequences of this theory, as the collapse of major firms led to a broader economic downturn, prompting government bailouts and regulatory responses like the Dodd-Frank Act. The ongoing debate around the best approach to manage "too big to fail" institutions continues to evoke diverse perspectives on financial stability and competition in the banking sector.
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"Too big to fail" theory
“Too big to fail” is an economic theory. It holds that certain banks and other institutions play such large roles in the economy that, if they were to fail, the results would be devastating, even for those not directly involved with that bank. To avoid such a financial catastrophe, federal governments have programs in place to safeguard these large institutions from failure.
This, however, creates other problems. If the government assists the largest institutions whenever they are in danger, it damages others’ ability to compete. Critics say that the largest banks can make risky, irresponsible business decisions, knowing that if the ventures do not work out, the government will protect the banks—a phenomenon called moral hazard. If the decisions succeed, the banks become even more successful. Smaller banks do not have the same safety net, making any competition between them unfair. The US government has made several attempts to restructure economic policy so the failure of one bank does not have such harmful effects, but their success has been limited.
Background
The phrase “too big to fail” was popularized during the Great Recession of the late 2000s, but the concept affected American economics throughout the twentieth century. In 1907, the stock market experienced a sudden crash. This caused many investors to attempt to withdraw their money from investment banks, hoping to save some money before the stock market dropped even lower. It was common practice for banks to use investors’ money for loans or other investments. When the economy was healthy, this typically worked and helped banks stay in business. But with so many investors attempting to withdraw large amounts at the same time, banks were overwhelmed. News spread that people were unable to access their money. Since the stock market relied on investors feeling confident that their money would be safe, the Panic of 1907 had negative effects that spread beyond any single bank. It prompted the US government to create the Federal Reserve, which became a last-resort lender to investment banks if a similar situation should arise.
During the Great Depression in the 1930s, commercial deposit banks faced a similar crisis on a much more widespread scale. With unemployment rising dramatically, many Americans were desperate for money and withdrawing from their savings accounts. Again, banks were unable to cover so many withdrawals, and many of them went out of business. In response, the government formed the Federal Deposit Insurance Corporation (FDIC), which helped banks cover costs like that in the future. The FDIC also regulated banks, preventing them from making high-risk choices with deposited money. This new relationship led to a period of relative stability.
In the 1970s, the Continental Illinois National Bank and Trust Company made some aggressive, high-risk investments and became one of the largest banks in the country by the early 1980s. By 1982, however, the bank was in trouble. Several of its loans were based on energy and fuel industries, which were going through sudden changes. Its customers worried that it would not survive much longer and began withdrawing funds. Continental Illinois was much bigger than earlier examples and conducted business with several other banks. Economists not only worried that if it went out of business, it would financially ruin its many customers, but also that the damage would spill into the other banks that it had dealings with. In the end, the FDIC directly intervened, purchasing billions of dollars of debt from Continental Illinois.
Topic Today
“Too big to fail” theory was a major aspect of the Great Recession of the late 2000s. It involved financial institutions handling mortgages irresponsibly. When most people buy homes, they only pay for a fraction of the cost upfront. A bank or other lender covers the rest of the cost, and the homeowner pays off that debt, or mortgage, over time.
Traditionally, lenders carefully reviewed potential homeowners’ financial situation before agreeing to a mortgage. But in the early twenty-first century, many lenders began selling mortgages to other lenders. This made the banks’ owners believe they would be in a more secure position if homeowners failed to pay their mortgages. Because of this confidence, lenders began seeking out more mortgages. They relaxed their standards on who they agreed to lend to. This resulted in many people taking on mortgages they could not afford.
Most lenders were not worried about this because they had sold the debt to other firms. They were also counting on firms that provided insurance for unpaid mortgages. This only shifted the problem, however. There were far more unpaid mortgages than most people expected, and even the largest, most successful insurance companies were in serious financial trouble.
As the government feared would happen with Continental Illinois, the impending failure of a few large firms had a devastating effect on other companies and people. The prices of houses dropped drastically across the country, and banks and lenders took massive losses. Many people were stuck with large debts and property that was worth much less than what they had paid for it. These events also affected the stock market, which plunged rapidly. This frightened many investors and hurt investment banks.
In 2008, Lehman Brothers declared bankruptcy. It was one of the largest investment banks in the country, and its collapse led to economic disruption throughout the United States. The effects even spilled into other countries. US leaders knew that other large financial institutions were on the brink of failure, and they did not want the situation to grow even worse. Late that year, the government passed the Troubled Asset Relief Program, which called for more than $700 billion to be loaned to struggling institutions.
The program, which became known as a bailout to the general public, drew mixed reactions. The failure of Lehman Brothers led to economic struggles for everyday Americans throughout the country. It demonstrated that one large institution could harm the entire nation if it failed. It was clear that government action was needed.
In 2010, the US federal government passed the Dodd-Frank Act. It created a council designed to observe and regulate large financial institutions. If the council determined that an institution had become too big to fail or was conducting irresponsible business, it could recommend responsive action, including breaking the institution into smaller entities. The act required institutions to carry enough money in reserve to avoid a crisis. It also called for institutions to have plans in place in case of emergency. However, many of its regulations were slow to take effect and difficult to enforce. The best way to handle “too big to fail” institutions remained a subject of debate.
Bibliography
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Amadeo, Kimberly. “The Great Recession of 2008: A Timeline and Its Effects.” The Balance, 24 Apr. 2022, www.thebalance.com/the-great-recession-of-2008-explanation-with-dates-4056832. Accessed 12 Jan. 2025.
"Continental Illinois: A Bank That Was Too Big to Fail." Federal Reserve History, 15 May. 2023, www.federalreservehistory.org/essays/failure‗of‗continental‗illinois. Accessed 12 Jan. 2025.
“H.R.4173-Dodd-Frank Wall Street Reform and Consumer Protection Act.” Congress.gov, www.congress.gov/bill/111th-congress/house-bill/4173/text. Accessed 12 Jan. 2025.
Koba, Mark. “Dodd-Frank Act: CNBC Explains.” CNBC, 30 Apr. 2013, www.cnbc.com/id/47075854. Accessed 12 Jan. 2025.
Labonte, Marc. “Systemically Important or ‘Too Big to Fail’ Financial Institutions.” Congressional Research Service, 24 Sept. 2018, fas.org/sgp/crs/misc/R42150.pdf. Accessed 12 Jan. 2025.
Whalen, Christopher. “Too Big to Fail: A History.” National Interest, 25 Sept. 2013, nationalinterest.org/commentary/too-big-fail-history-9127. Accessed 12 Jan. 2025.
Young, Julie. “Too Big to Fail: Definition, History, and Reforms.” Investopedia, 13 Nov. 2023, www.investopedia.com/terms/t/too-big-to-fail.asp. Accessed 12 Jan. 2025.