Too Big to Fail (TBTF)

[Globally Systematically Important Banks – GSIBs]

By Raman Khanna (L&T MHPS)

The “too big to fail” (TBTF) theory state that certain corporations, particularly BANKS and FINANCIAL INSTITUTIONS, that are so large and so interconnected that their failure would be substantially disastrous to the economy, and therefore they must be supported by government when they face potential failure. The term was popularized by US Congressman Stewart McKinney in a 1984. TBTF theory argues that, Banks and FIs, which are too large, should not be allowed to go bankrupt, since their impact in the economy will be catastrophic.

As per US Dodd-Frank Act, a bank is systematically important if it has $250 billion or more in assets. That covers 13 GSIBs including Commercial Banks, Investment Banks and Custodial Banks. These TBTF or GSIBs are subject to strict regulatory scrutiny, limited flexibility of increase in dividend, stock buy-backs and lesser room for leverages as compared to their smaller counterparts.

In India, the RBI has recognised three banks namely SBI, ICICI Bank, and HDFC Bank as domestic systemically important banks (DSIBs), which is along the lines of ‘too big to fail’ concept.

Indian banks are currently dealing with a huge pile of non-performing assets (NPAs), making provisions against NPAs, which have led them to take losses in the last couple of quarters. Further, ICICI and PNB Banks have been stained by controversies as well.

To deal with the banking crisis, the Narendra Modi Govt. introduced Insolvency and Bankruptcy Code (IBC) to clean-up NPA mess and announced a massive Rs 2.11 lakh crores bank recapitalisation plan for PSBs, which is being infused in tranches.

“Too big to fail” insurers – In line with TBTF, the insurance regulator (IRDAI) has also taken steps in to bring out a list of systematically important insurers (SIIs). It is likely that state-owned Life Insurance Corporation of India (LIC) will be on the list.

Global Definition

Federal Reserve Chair Ben Bernanke also defined the term in 2010: “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.” He continued that: “Governments provide support to too-big-to-fail firms in a crisis not out of favouritism or particular concern for the management, owners, or creditors of the firm, but because they recognize that the consequences for the broader economy of allowing a disorderly failure greatly outweigh the costs of avoiding the failure in some way

Bernanke cited several risks with too-big-to-fail institutions:

  • These firms generate severe moral hazard: “If creditors believe that an institution will not be allowed to fail, they will not demand much compensation for risks as they otherwise would, thus weakening market discipline; nor will they invest as many resources in monitoring the firm’s risk-taking. As a result, too-big-to-fail firms will tend to take more risk than desirable, in the expectation that they will receive assistance if they fail in future.”
  • It creates an uneven playing field between big and small firms.
  • The firms themselves become major risks to overall financial stability, particularly in the absence of adequate resolution tools. Bernanke wrote: “The failure of Lehman Brothers and the near-failure of several other large, complex firms significantly worsened the crisis and the recession by disrupting financial markets, impeding credit flows, inducing sharp declines in asset prices, and hurting confidence.

LEHMAN STORY triggered “TBTF”

Exactly eleven years ago, LEHMAN BROTHERS, America’s 4th largest investment bank collapsed amid a worsening subprime mortgage crisis. The fall of the bank was attributed to burst of the bubble that was created due to excesses built in the financial system over the years.

On September 15, 2008, LEHMAN BROTHERS filed for bankruptcy and officially sparked off the financial crisis of 2008. With $639 billion in assets and $619 billion in debt, Lehman Brothers bankruptcy filing was the largest ever. As a result, investors got a clear signal of the ongoing trouble in the market and ran for their money. There are several strong reasons that point out that the collapse of Lehman Brothers was just a symptom of existing troubles in the financial system rather than a cause.

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