Too Big to Fail

Topics: Basel II, Bank, Banking Pages: 8 (3153 words) Published: March 29, 2011
Too big to fail?
In this essay I will be addressing the “Too Big To Fail” (TBTF) problem in the current banking system. I will be discussing the risks associated with this policy, and the real problems behind it. I will then examine some solutions that have been proposed to solve the “too big to fail” problem. The policy ‘too big to fail’ refers to the idea that a bank has become so large that its failure could cause a disastrous effect to the rest of the economy, and so the government will provide assistance, in the form of perhaps a bailout/oversee a merger, to prevent this from happening. This is to protect the creditors and allow the bank to continue operating. If a bank does fail then this could cause a domino effect throughout the economy, i.e. bigger companies often purchase supplies through a smaller company who rely on the bank for a large portion of its income, the bank’s failure could then cause them to shutdown, meaning unemployment. So what the regulatory bodies need to decide is what is the more economically viable solution in the long run. The Governor of the Bank of England recently stated that 'if a bank is too big to fail - it is too big.' From 1929 – 1933 the US banking system failed and this caused one of the greatest economic recessions in history. During this period banks were allowed to fail as there was no regulatory body (Federal Deposit Insurance Corporation), no protection of depositors, and no real mechanism for an orderly dissolution of the existing management and transfer of what was valuable to a new, stronger bank. Friedman, Heller (1969 pp. 79-80) states that "We did learn something from the Great Depression... We learned that you ought to have numbers on the quantity of money.  If the Federal Reserve System in 1929 to 1933 had been publishing statistics on the quantity of money, I don't believe that the Great Depression could have taken the course that it did." Meaning that a stricter set of regulations was needed for the entire banking system. In 1988 the Basel I accord was introduced as it was felt that financial institutions were not retaining sufficient capital. The Basel I accord aimed to provide recommendations on ‘minimizing credit risk by creating a bank asset classification system’. This considered the risk of borrowers not being able to keep up with repayments. The Basel I accord became outdated with the advancement of the financial system, and so a modified set of guidelines were required. This took the form of the Basel II accord, introduced in 2004, and its role was to ‘create standards and regulations on how much capital financial institutions must have put aside’. [ 4 ] Putting money aside is essential to reduce the risks associated with the bank’s lending and investing activities. A prime example of a financial institution that was too big to fail, comes from the recent financial crisis, Bear Sterns of Wall Street. On March 16th 2008 the American Federal Reserve oversaw the buy-out by J P Morgan Chase, this move was seen as essential in ‘an unprecedented move to prevent the implosion of the US financial system’ (Jagger, Kennedy 2008). The financial crisis of 2007-2008 was by some measures the worst in the entire history of market capitalism, its cause stems from many different areas, the too big to fail policy poses many problems to the economy. In particular, moral hazard. This is the tendency of a “too big to fail” firm to make ‘bad loans based on an expectation that the lender of last resort...will bail out troubled banks’ (Liu 2008). It’s when the bank makes a bad investment, but suffers none of the consequences. This means that banks feel they are “protected”, so they may take on investments of higher risk than they would without this protection. This in turn increases the risk of a Central Bank (e.g. Federal Reserve) having to make a bailout. There is much risk associated with “too big to fail”; Credit risk, also known as default risk, is the name given to...
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