Too Big to Fail?

The mere mention of "too-big-to-fail" status for the nation's largest banks and financial businesses can spark intense debate

Deniz Anginer
Deniz Anginer

 ‘Too big to fail’ is one of those issues where everyone agrees something must be done, but approaches to dealing with the problem vary — sometimes dramatically, says finance assistant professor Deniz Anginer, who teaches at the Northern Virginia Center.

The Dodd-Frank Act of 2010 was passed to eliminate government bailouts for this select group of corporations. Still, implicit government guarantees to prevent future failure have not changed much since the Great Recession of 2008, according to Anginer.

He addressed that issue and related questions in testimony before a subcommittee of the U.S. Senate Committee on Banking, Housing, and Urban Affairs in a hearing on July 31. The hearing examined a report by the General Accounting Office on the expectations of government support for bank holding companies.

Expectations of support

The controversial too-big-to-fail doctrine holds that the government will not allow large financial institutions to fail if their failure would cause significant disruption to the financial system and economic activity, he says. Today, expectations of government support among large financial institutions and their investors continue, he says, and have significant effects on the economy.

Subcommittee chair Senator Sherrod Brown (D-OH) invited Anginer to testify at the hearing in view of a related study he had coauthored.

Heated debate

There were four of us there to testify. We each spoke for about five minutes, and then the floor was opened for discussion, Anginer recalls. The conversation became quite heated at times.

In his testimony, Anginer mentioned specific ways in which the doctrine has a negative impact on financial markets.

One impact is that the price of bonds that too-big-to-fail companies issue reflects expectations that the government will back their debts, allowing the companies to borrow at lower rates than small to mid-size competitors.

Dulling discipline

Too-big-to-fail status also distorts how debt prices reflect risk. An implicit government guarantee dulls market discipline by reducing investors’ incentives to monitor and price the risk-taking of large financial institutions, Anginer told his audience, which comprised senators, lobbyists, and the financial press.

In our analyses, we show that while a positive relationship exists between risk and cost of debt for medium and small-sized institutions, this relationship is 75 percent weaker for the largest institutions. Changes in leverage and capital ratios are, likewise, less sensitive to changes in risk for these large institutions.

The implicit guarantee gave too-big-to-fail institutions an average funding cost advantage of approximately 30 basis points per year from 1990 to 2012, peaking at more than 100 basis points in 2009. The total value of the subsidy amounted to about $30 billion per year on average over the 1990-2012 period, topping $150 billion in 2009.

Implicit guarantees

Anginer and his colleagues posit that despite its no-bailout pledge, the Dodd-Frank Act leaves the door open to future too-big-to-fail bailouts: The Federal Reserve could disguise a bailout by offering a broad-based lending option to a group of financial institutions; Congress could amend or repeal the law; Congress could also allow regulators great leeway that would protect large financial institutions and their creditors.

Anginer closed his testimony by calling for greater governmental transparency. He pointed out that when governments implicitly guarantee support for too-big-to-fail firms, they are not generally required to make a financial commitment or outlay.

Implicit guarantees lack the transparency and accountability that accompany explicit policy decisions. Taxpayer interests could be better served, in both good times and bad, by estimating on an ongoing basis the accumulated value of this subsidy. Public accounting of accumulated too-big-to-fail costs might restrain those government actions and policies that encourage too-big-to-fail expectations.

TBTF insurance?

As for ideas for solutions to the quandary undergoing discussion in Washington, Anginer mentions instituting fees for too-big-to-fail insurance, much like those banks pay for FDIC backing of customers’ deposits.

Anginer based his testimony on the article, The End of Market Discipline? Investor Expectations of Implicit Government Guarantees, which he coauthored with Viral V. Acharya, of New York University, and A. Joseph Warburton, of Syracuse University.

Read the full text of his testimony.

Anginer was a financial economist at the World Bank’s development research group before joining Pamplin. His research has been featured in the media, including the New York Times and Bloomberg Businessweek.

— Susan Felker


Virginia Tech Pamplin College of Business Virginia Tech Pamplin College of Business Magazine Spring 2014

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