The 1980s: Bailout of Continental Illinois Bank and Birth of the Too Big To Fail Banking Model
“We have a new kind of bank. It is called too big to fail, TBTF, and it is a wonderful bank,” declared US Congressman Stewart B. McKinney in 1984 after the federal government’s $4.5 billion bailout to rescue the Continental Illinois Bank. McKinney coined the name of what later was considered one of the factors that led to the financial crisis of 2008.
The model relies on a simple fact: when the consequences on the economy of an important bank’s failure are considered greater than the amount of money required to rescue it, a government bailout is the most likely outcome, either through a merger or injection of government capital.
The expansion of economic neoliberalism witnessed in the 1980s, in particular through the elections of Margaret Thatcher in the UK in 1979 and Ronald Reagan in the US in 1980, encouraged free market and “laissez-faire” politics. Countries were opening their frontiers to free flows of capital and the banking system was expanding faster than ever before.
Laissez-faire capitalism gave banks greater freedom with respect to attaining capital and making investment decisions, consequently promoting a more risk-taking behaviour. The free-market environment gave birth to the “TBTF” banks. Ironically, as anti-capitalist as the concept is, the contradiction never raised strong doubt about the risks involved for the economy. Perhaps, investors were blinded by the explosion of the banking industry. The TBTF banks took advantage of the free-market era to empower and enrich themselves, while unknowingly becoming more and more dependent on government intervention in the event of an economic slump.
2008: Role of Too Big To Fail Banks in the Financial Crisis
In 2010, Federal Reserve Chair Ben Bernanke gave a more precise definition of the term TBTF: “A too-big-to-fail firm is one whose size, complexity, interconnectedness, and critical functions are such that, should the firm go unexpectedly into liquidation, the rest of the financial system and the economy would face severe adverse consequences.”1
Reading this definition today, we are instantaneously reminded of past events such as the bailouts of Bear Stearns, AIG, and Merrill Lynch in 2008. More broadly, this reflects the passing of the Emergency Economic Stabilization Act of 2008 and the “bailout” of the US financial system – creating the $700 billion Troubled Asset Relief Plan (TARP) to purchase the failing banks’ distressed assets. Alternatively, we witnessed the consequences that followed the bankruptcy of Lehman Brothers – a TBTF bank by most definitions – leading us to wonder if the economic consequences would have been less severe had the government intervened.
The banks were truly “too big to fail” and they knew it. Their creditors knew it too, and figured that they would end up being paid, even in case of financial distress – and they were right. During the 2008 financial crisis, most bondholders, even some holding subordinated or junior debt, were left untouched at the expense of taxpayers.
November 10, 2014: The Total Loss-Absorbing Capacity Plan unveiled by the Financial Stability Board
At the 2013 G20 Summit held in St. Petersburg, the Financial Stability Board (FSB) was called to collaborate “with standard-setting bodies to assess and develop proposals by end-2014 on the adequacy of global, systemically-important financial institutions’ loss-absorbing capacity when they fail.”2
The explicit mission given to the FSB was to create regulations that would make the important banks no longer “too big to fail.” This means that their failure should have no threat to the wider economy, and thus not require government intervention.
On November 10th 2014, the FSB presented the “total loss-absorbing capacity” (TLAC) plan. The global regulation on capital is to be set by a G20 Summit in 2015. It is composed of two main lines of regulations. First, important banks will be obligated to have a buffer of bonds or equity of at least 16-20% of their risk-weighted assets, starting from January 2019. The objective of the capital requirement is to make the banks more solvent and, thus, less vulnerable to future crises. Secondly, the principle of “bailing in” creditors is to be implemented. This implies that regulators would be given the ability to mandate that creditors actually suffer losses on part of their investments, in case of financial distress, to bail in a bank before taxpayers are called up on to bail it out. This would reduce aggressive lending and protect taxpayers should another financial crisis occur.
Some concerns about the effectiveness of the new regulations can be raised. In fact, even if the solvency problem of the important banks is resolved, the complicated structure of the big banks makes them very difficult to terminate operations, as shown by the rejection of the “living will” of 11 big banks by American officials last August. In addition, only 27 global banks – such as Citigroup and HSBC – will have to comply with the TLAC requirements, chiefly because the new buffer would not apply to smaller banks and big banks in China and other emerging markets. As a result, only the bigger, more globally-established players will have to raise huge amounts of capital. For example, analysts at Citi estimated that it would cost European banks 3 percent of their 2016 profit if they were given until 2019 to implement the changes.
The impact on the future global banking is still uncertain. The costs incurred by the targeted banks might hurt their competitiveness and force them to reduce their size, but smaller might also mean safer. If the measures are implemented, we will not know whether the TBTF model of banking has successfully disappeared until witnessing how the banks react to the next financial crisis.