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A Tale of Titans: The Too Important to Fail Conundrum

Folklore is riddled with tales of a lone actor undoing a titan: David and Goliath; Heracles and Atlas; Jack and the Beanstalk, to name a few.

Financial institutions seen as too important to fail have become even larger and more complex since the global crisis. We need look no further than the example of investment bank Lehman Brothers to understand how one financial institution’s failure can threaten the global financial system and create devastating effects to economies around the world.

The behavior of financial institutions can be a risk to the whole financial system if they fail. When dealing with a potential failure, governments are left with few policy options and they may choose to step in and bail them out with taxpayers’ money to prevent any cascading effects of failure.

Bailouts are expensive. For countries that used public funds, estimated costs of direct support in the recent crisis reached on average about 7 percent of GDP.

We’ve been looking at how to fix the too important to fail problem for a number of reasons. The big picture matters; the stability of the financial system, avoiding crises, and the hardships that accompany. Most importantly, to spare taxpayers the expense of bailouts, and also to reinstate market discipline, eliminate moral hazard, and level the playing field. These institutions also need to be easier to manage, supervise and resolve if they do fail.

Our research shows that addressing the size of banks cannot solve the problem. Size alone doesn’t capture the full dimension of the issue.

The growing complexity and connections to other institutions and financial markets, and the lack of substitutes providing similar services magnify the propensity to trigger panics. These traits make such institutions “too important to fail” rather than “too big to fail.”

We favor market based measures to help reduce the likelihood and impact of a failure, including

The problem isn’t getting any smaller

Institutions that were more interconnected appear to have had a higher likelihood of distress during the recent crisis than other financial institutions. The size of an institution relative to its home country economy or its financial system played a key role in authorities’ decisions about whether to bail it out in the event of distress.

The too-important-to-fail institutions have grown in importance. Their share of assets doubled during 2000-09, reaching a quarter of the total global assets.  The growth of their assets, ranging from $50 billion to $3 trillion, in some cases outpaced the growth of their national economies.

The implicit or explicit government backing gave such institutions funding advantage: for example, the largest banks in the United States have been able to borrow funds at lower rates than smaller banks, and this advantage widened after the crisis to about 80 basis points.

Time will tell

Global regulators have come up with a new set of tighter rules for all banks, known as Basel III, as a starting point to make the system less risky and address a number of regulatory issues. Countries have until 2018 to comply with the new rules. A series of policy measures targeted specifically at systemically important financial institutions, or SIFIs for shorthand, have been put forward, including by the Financial Stability Board. We support these measures that serve to internalize the risks SIFIs take. Specifically:

Implementation may take several years, however, while systemic institutions continue to grow in size and complexity, and may resume their risky practices. So in the interim, we’d like to see rapid, credible, and visible actions.

This would require systemically important financial institutions to hold more loss-absorbing capital above what is required under Basel III, accompanied with intensive and proactive supervision of the regulated entities and efforts to limit regulatory arbitrage within and across borders and sectors.

Given the financial system is not out of the woods yet, one could worry that the next failure of a systemically important institution could again prompt a government funded rescue at a time when government finances are fragile in many countries.

This is a very good reason to implement interim measures to signal that the world is united to deal with the problem.