Too Big to Fail: The Hazards of Bank Bailouts

Too Big to Fail: The Hazards of Bank Bailouts

by Gary H. Stern, Ron J. Feldman

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The potential failure of a large bank presents vexing questions for policymakers. It poses significant risks to other financial institutions, to the financial system as a whole, and possibly to the economic and social order. Because of such fears, policymakers in many countries —developed and less developed, democratic and autocratic —respond by


The potential failure of a large bank presents vexing questions for policymakers. It poses significant risks to other financial institutions, to the financial system as a whole, and possibly to the economic and social order. Because of such fears, policymakers in many countries —developed and less developed, democratic and autocratic —respond by protecting bank creditors from all or some of the losses they otherwise would face. Failing banks are labeled "too big to fail" (or TBTF). This important new book examines the issues surrounding TBTF, explaining why it is a problem and discussing ways of dealing with it more effectively.

Gary Stern and Ron Feldman, officers with the Federal Reserve, warn that not enough has been done to reduce creditors' expectations of TBTF protection. Many of the existing pledges and policies meant to convince creditors that they will bear market losses when large banks fail are not credible, resulting in significant net costs to the economy. The authors recommend that policymakers enact a series of reforms to reduce expectations of bailouts when large banks fail.

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"Stern and Feldman have written an important book on the too-big-to-fail problem....This book deserves to be widely read in the banking regulation and supervisory world." —Frederic Mishkin, Journal of Economic Literature

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Too Big to Fail

The Hazards of Bank Bailouts
By Gary H. Stern Ron J. Feldman

Brookings Institution Press

Copyright © 2004 Brookings Institution Press
All right reserved.

ISBN: 0-8157-8152-0

Chapter One

Introduction: Our Message and Methods

Summarizing the warnings and options of this book requires a little background for the uninitiated. We start with the trivial observation that banks fail. Some banks fail without notice. Other failing banks capture the attention of policymakers, often because of the bank's large size and significant role in the financial system. Determining the appropriate policy response to an important failing bank has long been a vexing public policy issue. The failure of a large banking organization is seen as posing significant risks to other financial institutions, to the financial system as a whole, and possibly to the economic and social order. Because of such fears, policymakers in many countries-developed and less developed, democratic and autocratic-respond by protecting uninsured creditors of banks from all or some of the losses they otherwise would face. These banks have assumed the title of "too big to fail" (TBTF), a term describing the receipt of discretionary government support by a bank's uninsured creditors who are not automatically entitled to government support (for simplicity we use creditors and uninsured creditors synonymously from here on).

To the extent that creditors of TBTF banks expect government protection, they reduce their vigilance in monitoring and responding to these banks' activities. When creditors exert less of this type of market discipline, the banks may take excessive risks. TBTF banks will make loans and other bets that seem quite foolish in retrospect. These costs sound abstract but are, in fact, measured in the hundreds of billions of dollars of lost income and output for countries, some of which have faced significant economic downturns because of the instability that too big to fail helped to create. This undesirable behavior is frequently referred to as the "moral hazard" of TBTF protection. Such behavior wastes resources.

Our Message

Despite some progress, our central warning is that not enough has been done to reduce creditors' expectations of TBTF protection. Many of the existing pledges and policies meant to convince creditors that they will bear market losses when large banks fail are not credible and therefore are ineffective. Blanket pledges not to bail out creditors are not credible because they do not address the factors that motivate policymakers to protect uninsured bank creditors in the first place. The primary reason why policymakers bail out creditors of large banks is to reduce the chance that the failure of a large bank in which creditors take large losses will lead other banks to fail or capital markets to cease working efficiently.

Other factors may also motivate governments to protect uninsured creditors at large banks. Policymakers may provide protection because doing so benefits them personally, by advancing their career, for example. Incompetent central planning may also drive some bailouts. Although these factors receive some of our attention and are addressed by some of our reforms, we think they are less important than the motivation to dampen the effect of a large bank failure on financial stability.

Despite the lack of definitive evidence on the moral hazard costs and benefits of increased stability generated by TBTF protection, the empirical and anecdotal data, analysis, and our general impression-imperfect as they are-suggest that TBTF protection imposes net costs. We also argue that the TBTF problem has grown in severity. Reasons for this increase include growth in the size of the largest banks, greater concentration of banking system assets in large banks, the greater complexity of bank operations, and, finally, several trends in policy, including a spate of recent bailouts.

Our views are held by some, but other respected analysts come to different conclusions. Some observers believe that the net costs of TBTF protection have been overstated, while others note that some large financial firms have failed without their uninsured creditors being protected from losses. However, even analysts who weigh the costs and benefits differently than we do have reason to support many of our reforms. Some of our recommendations, for example, make policymakers less likely to provide TBTF protection and address moral hazard precisely by reducing the threat of instability. Moreover, our review of cases where bailouts were not forthcoming suggests that policymakers are, in fact, motivated by the factors we cite and that our reforms would push policy in the right direction.

A second camp believes that TBTF protection could impose net costs in theory, but in practice legal regimes in the United States-which other developed countries could adopt-make delivery of TBTF protection so difficult as to virtually eliminate the TBTF problem.

We are sympathetic to the general and as yet untested approach taken by U.S. policymakers and recognize that it may have made a dent in TBTF expectations. In the long run, however, we predict that the system will not significantly reduce the probability that creditors of TBTF banks will receive bailouts. The U.S. approach to too big to fail continues to lack credibility.

Finally, a third camp also recognizes that TBTF protection could impose net costs but believes that there is no realistic solution. This camp argues that policymakers cannot credibly commit to imposing losses on the creditors of TBTF banks. The best governments can do, in their view, is accept the net costs of TBTF, albeit with perhaps more resources devoted to supervision and regulation and with greater ambiguity about precisely which institutions and which creditors could receive ex post TBTF support.

Like the third camp, we believe that policymakers face significant challenges in credibly putting creditors of important banks at risk of loss. A TBTF policy based on assertions of "no bailouts ever" will certainly be breached. Moreover, we doubt that any single policy change will dramatically reduce expected protection. But fundamentally we part company with this third camp. Policymakers can enact a series of reforms that reduce expectations of bailouts for many creditors at many institutions. Just as policymakers in many countries established expectations of low inflation when few thought it was possible, so too can they put creditors who now expect protection at greater risk of loss.

The first steps for credibly putting creditors of important financial institutions at risk of loss have little to do with too big to fail per se. Where needed, countries should create or reinforce the rule of law, property rights, and the integrity of public institutions. Incorporating the costs of too big to fail into the policymaking process is another important reform underpinning effective management of TBTF expectations. Appointment of leaders who are loath to, or at least quite cautious about, providing TBTF bailouts is also a conceptually simple but potentially helpful step. Better public accounting for TBTF costs and concern about the disposition of policymakers could restrain the personal motivations that might encourage TBTF protection.

With the basics in place, policymakers can take on TBTF expectations more credibly by directly addressing their fear of instability. We recommend a number of options in this regard. One class of reforms tries to reduce the likelihood that the failure of one bank will spill over to another or to reduce the uncertainty that policymakers face when confronted with a large failing bank. These reforms include, among other options, simulating large bank failures and supervisory responses to them, addressing the concentration of payment system activity in a few banks, and clarifying the legal and regulatory framework to be applied when a large bank fails.

Other types of reforms include reducing the losses imposed by bank failure in the first place and maintaining reforms that reduce the exposure between banks that is created by payment system activities. These policies can be effective, in our view, in convincing public policymakers that, if they refrain from a bailout, spillover effects will be manageable. Such policies therefore encourage creditors to view themselves at risk of loss and thus improve market discipline of erstwhile TBTF institutions.

We are less positive about other reforms. A series of reforms that effectively punish policymakers who provide bailouts potentially also could address personal motivational factors. However, we are not convinced that these reforms are workable and believe that they give too much credence to personal motivations as a factor to explain bailouts. The establishment of a basic level of supervision and regulation (S&R) of banks should help to restrict risk-taking, although we view S&R as having important limitations.

Finally, policymakers have a host of other available options once they have begun to address too big to fail more effectively. For example, policymakers could make greater use of discipline by creditors at risk of loss. Bank supervisors could rely more heavily on market signals in their assessment of bank risk-taking. Deposit insurers could use similar signals to set their premiums.

One may agree with our arguments in concept but find them lacking in real-world pragmatism or realpolitik. A compelling case for relying on analytical rather than political principles in addressing the failure of large banks was made nearly thirty years ago-a full decade before the term too big to fail became commonplace:

To many practical people the suggestion that a large bank be allowed to fail may seem to represent dogmatic adherence to standard economic doctrine, a victory of ideology over pragmatic common sense. A pragmatic position is to argue that, yes, business failures do serve a useful function, but in the specific case of a large bank, the costs of allowing failure outweigh the costs of supporting it. After all, the social costs of failure are immediate, while the advantages of permitting failure are indirect and removed into the future. But this pragmatic position should be rejected because it ignores externalities over time. If we prop up a large bank because the direct costs of doing so outweigh the cost of allowing it to fail, then the next time a large bank is in danger of failing it is likely to be propped up too. But in the future the same benefit will then probably be accorded to medium-sized banks. And from there it is likely to spread to small banks, to other financial institutions, and ultimately to other firms. When one includes the cost of moving down this slippery slope in the cost of saving a large bank, then the costs of allowing it to fail may seem small by comparison. At a time when devotion to pragmatism is so much in the air, it is useful to consider also the benefits of sticking to one's principles even in hard cases.

Our Methods

Describing an author's approach runs the risk of self-indulgence. After all, the reader can judge the product on its merits. But a brief description of what we hope to accomplish might help prospective readers to set their expectations. The types of arguments made in this book and the evidence on which we rely reflect our target audience and what we perceive to be our comparative advantages. Fortunately, there is a large degree of intersection between these two rationales.

In terms of audience, we intend this book to help the wide range of staff practitioners, as well as the policymakers they support, to confront the TBTF problem. Although such an audience has a growing appreciation for concepts like moral hazard and the reasoning of economists, it is unlikely to find a treatment of the relevant issues that is suitable for academic journals to be approachable or convincing. Instead, it is likely to value clarity, concreteness, and conclusions that can be internalized.

In terms of our comparative advantages, they are twofold and relate to our interests and experience. We have policy experience-most notably Stern's eighteen years of service as a Federal Reserve Bank president, making him the most senior, active U.S. central banker. We both have spent a good part of our careers trying to explain the central findings of technical experts to an interested but frequently lay audience. Typically, we have tried to move from general findings to policy recommendations. Although this book contains some new analysis of data and, we hope, an insight or two that others have not made or stressed, it is not a source for mathematical models or sophisticated uses of empirical methods.

Many in our target audience of practitioners would just as soon skip empirical models in the first place. An explanation for our strategy is unnecessary for them. But given the central role that economists have played in highlighting the TBTF problem, it is worth considering the merits of an approach that relies on deductive reasoning and economic logic rather than academic research. We have already argued that a simple and direct approach is likely to be more influential with the target audience than the converse. But what is influential could very well be wrong. We have persuaded ourselves that another rationale justifies our approach: namely, that policymakers must make decisions based on the best available information, and what is known today about too big to fail frequently requires reasoning and exposition to fill in substantial analytical gaps.

The truth, as demonstrated by rigorous analysis and derived through consensus, does not exist when it comes to many of the issues related to too big to fail. For some issues, the relevant data have not been collected and perhaps cannot easily be collected in any reasonable time period. For example, there is no comprehensive list of countries in which uninsured creditors of banks have received government protection. Records describing the size and type of bailouts that creditors have received are not readily available. Simply put, the basic facts are elusive. More generally, data on and applied analysis of too big to fail are made quite difficult by the implied nature of the support. To be sure, some data have been collected and some analysis completed. Such work is often based on an after-the-fact review of a single event with real limitations because of a lack of scientific controls. There is also theoretical work, but it often abstracts so far from institutional detail as to provide little guidance. These models do not let policymakers know if they should support creditors of one large bank but not another.

As a result, the environment for policymakers is characterized by opaqueness and uncertainty. Policymakers and their staffs could wait until a long-term research program is complete before they take action. Acting today with sub-par information could actually make things worse, and history is replete with such cases.


Excerpted from Too Big to Fail by Gary H. Stern Ron J. Feldman Copyright © 2004 by Brookings Institution Press . Excerpted by permission.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

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From the Publisher

"This is a valuable and comprehensive treatise on TBTF, a critically important policy issue that needs to be addressed well before another banking or financial crisis occurs. Policymakers, regulators, government officials, legislators, and private financial companies should read and heed the authors' analysis and recommendations." —Richard M. Kovacevich, Chairman, Wells Fargo

Meet the Author

Gary H. Stern is president and chief executive officer of the Federal Reserve Bank of Minneapolis. Ron Feldman is senior vice president at the Federal Reserve Bank of Minneapolis. Paul A. Volcker was chairman of the Federal Reserve from 1979 to 1987.

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