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Congressional Research Service (CRS)

 

Systemically Important or “Too Big to Fail” Financial Institutions

Marc Labonte, Specialist in Macroeconomic Policy

September 19, 2014

http://fas.org/sgp/crs/misc/R42150.pdf

[full-text, 61 pages]

 

Summary

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

policy makers 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

create 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. If so, they could have a

funding advantage compared with other banks, which some call an implicit subsidy. S.Con.Res.

8, passed by the Senate on March 22, 2013, and H.Con.Res. 25, as amended and passed by the

Senate on October 16, 2013, create a non-binding budget reserve fund that allows for future

legislation to address the TBTF funding advantage.

 

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; enhancing 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, as 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)

address all of these policy approaches. For example, it created an enhanced prudential regulatory

regime administered by the Federal Reserve for non-bank financial firms designated as

“systemically important” by the Financial Stability Oversight Council (FSOC) and banks with

more than $50 billion in assets. About 30 U.S. bank holding companies and a larger number of

foreign banks have more than $50 billion in assets, and the FSOC has designated two insurers

(AIG and Prudential) and GE Capital as systemically important. According to the insurer

MetLife, FSOC has proposed to designate it as well. In addition, eight banks headquartered in the

United States will be assessed capital surcharges under Basel III. H.R. 4881, ordered to be

reported by the House Financial Services Committee on June 20, 2014, would place a one-year

moratorium on FSOC designations. H.R. 5016, which passed the House on July 16, 2014, would

not allow any funds to be used to designate a non-bank as systemically important or as posing a

systemic threat to financial stability. S. 2270, as passed by the Senate, and H.R. 5461, as passed

by the House, would allow regulators to exempt insurers from bank capital requirements (the

“Collins Amendment” to the Dodd-Frank Act).

 

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 has not been used to date, and has some similarities to how the FDIC

resolves failing banks. Statutory authority used to prevent financial firms from failing during the

crisis has either expired or been narrowed by the Dodd-Frank Act.

 

Contents

Introduction ...................................................................................................................................... 1

Economic Issues .............................................................................................................................. 2

Context ...................................................................................................................................... 2

Economic Effects of Too Big to Fail ......................................................................................... 4

Do TBTF Firms Enjoy a Funding Advantage or Implicit Subsidy? .................................... 7

Policy Options ................................................................................................................................. 8

Policy Before and During the Crisis .......................................................................................... 8

Policy Options and the Policy Response After the Crisis ........................................................ 10

End or Continue “Bailouts”? ............................................................................................. 11

Limiting the Size of Financial Firms ................................................................................. 15

Limiting the Scope of Financial Firms .............................................................................. 17

Regulating TBTF ............................................................................................................... 20

Minimize Spillover Effects ............................................................................................... 26

Resolving a Large, Interconnected Failing Firm ............................................................... 28

Selected Legislation in the 113th Congress .................................................................................... 33

Conclusion ..................................................................................................................................... 35

 

Tables

Table 1. Large Financial Firms’ Share of Total Industry Revenue, 1997-2007 ............................... 4

Table 2. U.S. Banks Identified as G-SIBs and Capital Surcharge Recommended by the FSB .............................. 25

 

Appendixes

Appendix. Selected Historical Experiences With “Too Big To Fail” ............................................ 39

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