Too Big to Fail: A Worsening Problem?

One of the themes stressed by the BarCap research is that the funding problems of weak banks are likely to see stronger, better-funded, European banks growing bigger at their expense, thus exacerbating the Too Big to Fail problem.

This isn’t a theoretical issue. Former IMF Chief Economist Simon Johnson has been flagging for some time that the crisis has seen the biggest six banks in the US substantially increase their overall share of bank assets. Johnson’s recent AEA presentation is well worth reading. It paints a depressing picture in which the rescue of the financial sector has boosted and emboldened the leading banks and, with a timid and perhaps compromised US Treasury unwilling to act, Johnson seems to be predicting an even larger crisis down the road.

It’s hard to know how much to agree with this diagnosis. Johnson is hardly the only person discussing this as a serious issue. For instance, Mervyn King has spoken in very strong terms about this issue, for instance in this speech which has many choice quotes including:

Anyone who proposed giving government guarantees to retail depositors and other creditors, and then suggested that such funding could be used to finance highly risky and speculative activities, would be thought rather unworldly. But that is where we now are.

Andy Haldane’s “doom loop” speech is further evidence of how seriously the Bank of England takes this issue.

In the US, while the Treasury has clearly whiffed so far on this issue, influential voices such as Paul Volker and St. Louis Fed President Thomas Hoenig have also emphasised the importance of dealing with TBTF. Even more officially, the Basle Committee is apparently now looking in to special treatment of global banks that are deemed to big to fail. So perhaps there are reasons to think that, um, this time might be different.

Still, with leading international banks making money again and huge bonuses back, it’s hard not to get the sinking feeling that the bankers will be able to water down proposals for tighter regulation and that we could heading down the same path yet again.

43 replies on “Too Big to Fail: A Worsening Problem?”

The ‘too big to fail, too big to be’ argument often seems like it runs to a Minskyan beat, especially with the exposure of Ponzi finance, the extension of government largesse and concentration of banking activities. Plinoff,(, writes that

“during the 1980–2003 period the number of banking organizations decreased from about 16,000 to about 8,000, and mergers of healthy institutions were by far the most important cause of that consolidation.”

After 2003, we know that mergers in banks increased. Concentration and consolidation created the conditions Johnson describes in his presentation.

One of the big parts of the Minsky argument is that increased concentration creates the ‘too big to fail’ type bank, which exacerbates the effects of the next big cycle.

A great summary of Minsky’s work is here:

@ Karl

the only way it seems to me that we can have (a) the much needed consolidation within the banking sector and (b) not end up with TBTF banks, would be something along the lines of Glass-Steagal being re-enacted. I don’t see anything else working. Massive amounts of regulation might, in theory, work, but as Elizabeth Warren said, regulation will, eventually, fail. Knowing what to do when it fails is the key to the problem.

We could have what has been mentioned many times before, living wills for all the banks. Where it is explicitly stated that the government does not stand behind the bonds of the banks.

If investors purchase the bonds knowing that there is no implicit or explicit guarantee they can price the bonds accordingly with full knowledge of the risks involved.
We should also spell out exactly how the government would take over the payment system immediately from any defaulting or insolvent banks.

@ DE

the problem is that its highly debateable that even with a “living will” in place (which is a great idea for 95% of banks), that the UK and European financial markets could cope with the likes of HSBC, BNP or Santander going bust.

Much bigger usage of contingent convertible bonds (CoCo) combined with some form of living wills and bigger capital reserves (say 12% minimum T1 long term) are probably a more realistic answer.

@Eoin Bond.

I understand the long term attraction of CoCos, but in the immediate term I don’t see them as a viable solution.

My knowledge of CoCos is far from encyclopedic, but from what I understand they give the banks the opportunity to convert subordinated debt in CoCos that look and pay like senior dated debt, but if/when the bank develops a capital crisis the CoCos convert into equity.

While it would be great if this had been introduced in the good times, is it not a bit late now?

The banks at the moment can, (again as far as I know), avoid paying coupons on subordinated debt under EU guidelines (for example Lloyds in the UK have been told not to pay coupons on subordinated debt until 2012). So, their current debt structure is causing less of a cash draw than if they had CoCos on which coupons would have to be paid.

It seems to me that if the bank is in a situation where CoCos seem like a good idea, it would be better to go straight for a debt/equity swap rather than jumping through the CoCo loop.

Unless, of course, the whole CoCo idea just exists to make debt/equity more palatable to current shareholders. (look, we are just rearranging our debt, not actively diluting our shareholders. Oh look, turns out the CoCos have converted, ah well, we tried..)

@ Lorcan

you’re spot on that right now its would be extremely difficult to roll out CoCo’s across the sector. Indeed, it’d be extremely difficult to do it for the next 5 years or so i’d say. However, long term they remain one of the better solutions to banking sector capital losses in a downturn. And in the short to medium term, would writing a living will for the likes of HSBC, or trying to break up the likes of JP Morgan via Glass-Seagall type legislation, be all that much more likely to succeed (without significant fallout)?

@ DE

in the global/European context its absurd that AIB and BOI are TBTF, and you’re probably right that some sort of managed wind down wouldn’t be as catastrophic as it would have been say a year ago. However it would be by no means a painless process, and a short term Irish bank run couldnt be ruled out. You’d also have the problem of who steps into the vaccuum left by a 35% market share folding. However, that said, do you think the markets could handle HSBC going whallop? As i said, living wills work in theory, but not necessarily in practise for all banks. Maybe over the long term the markets can re-adjust to the idea of truly risky banks, but its going to require a certain amount of government support in the background to get us there.

As for the 12%, that would be the long term target, staggered from 8% to 10% to 12% over the next 5 or 6 years. But we’d end up with much more expensive cost of capital as a result, so again, there’s no easy solution to this.

@Bond. Eoin Bond
Well IMO if it turns out that the markets cannot digest a bank with a living will it should be split.
Alternatively the government should automatically be given an equity stake in the bank to compensate for the risks it is accepting.

Or let the shareholders decide if they want less equity or lots of bits of smaller banks.

The post seems not enthusiastic about “stronger, better-funded, European banks”. I would like to remind you that there is not going to much of a recovery without properly functioning banks, and a system that is sufficiently attractive for private capital. In the USA, the authorities have taken the sensible decision to allow weaker banks fail, and competition flourish to some extent.

I’d be more worried by the systemic threats from massive public deficits, and the inability of governments to tackle contingent public liabilities, than TBTF just now. Of course both problems need to be tackled. But let’s not get distracted from the more important, immediate tasks. Some politicians are only too happy to have whipping boys. But I’d hope most economists could rise above the populist furore.

Likewise, for Ireland, hopefully we will see strong public finances, sooner rather than later. Strong working banks would be a step in that direction.

Bond. Eoin Bond…
“Regulation will fail” Lack of political will sapped by too many $$$$$! Regulation does not fail, humans do. We have police for them! Bread and water and then beheading…….hmmm might help regulation succeed!

There is no need for a bank to have a joint stock company with limited liability. Lloyds worked for many centuries, until fraud took over. Where there is money there will be fraud. Crime can be minimized, but not if there is a reliance on some concept of a market in fraud!

Government has very few legitimate functions, but equal treatement before just laws is one! Glass etc was repealled at the behest of bankers! It was ever thus. Was a warning really necessary? People who allow that are corrupt beyond saving and now they want to know what happened. ..!

Joint stock companies are a vehicle for fraud and should not exist in those areas of the economy where fraud is a systemic risk: Fand I, Finance and Insurance!

This is a secular deflation!!!!! Get it into yopur heads, there will be no growth unless it is at the expense of other economies. Deflationary spiral, people. Check out Japan! Let the banks find their true size and then capitalize them. The amounts involved will be much less. So the losses will be also!

separating the bank as a utility from the roulette wheel side of operations is key, volker has said it amongst others, part of the issue is that ‘bank’ isn’t just about traditional saver/borrower intermediation any more, it has several guises but when one company encompasses all of them you essentially give guarantees for things that shouldn’t have it, and yet if you don’t give the guarantee then the part that should have it may collapse along with the investment arm.

so the simple answer is let any bank be as large as it wants to be, there are benefits in large operations in terms of costs to borrowers, profitability for shareholders, efficiency of systems, less confusion on international payments etc. big banks have a societal benefit, just not when they have to be bailed out, if they can’t stand up on their own they should close just like any other business, or be sold off, just like any other business.

the state and regulators need to take the initiative and charge more for insurance (our own scheme had a paltry 527m in it in 2008!) and separate operations so that everybody, shareholders included, know that one section is covered, another isn’t – better yet, force them to break apart and operate as distinct firms where one is a branch of the business that must be treated at arms length rather than all under one umbrella.

@ Karl D.

“if they can’t stand up on their own they should close just like any other business”

Is this a shift in position from your pro-NAMA days, when you supported taxpayer funds being used to rescue banks from insolvency?

As Stephen Kinsella points outs, the drive towards increased consolidation has been long established. Do we know that this consolidation added value to the banks and shareholders prior to the credit crunch? The same drive is evident in other industries, but there is quite a bit of evidence that many mergers and acquisitions destroy value. If this is a natural economic force in the industry it will need concerted trust-busting effort at a multinational level – similar to the Sherman Act writ large (and with Glass-Steagal thrown in for good measure). If genuine economies of scope and scale are unexploited the present value of these losses to citizens might be far less than the costs to citizens of periodic financial meltdowns.

As Karl notes, the noises from the US policy and regulatory areas are not encouraging. In the EU, Neelie Kroes, who has proved to be a very effective Competition Commissioner, has been sidelined. Hard-nosed nationalism and, in the EU, a mixture of regionalism is preventing the action that is required. Nobody wants to jump first and to hobble their banks. It will probably fall to the gnomes in Basle – and we could be waiting a long time for something quite anaemic.

@Paul, there are substantial economies of scale in banking, originating particularly in the scope that exists to defray the high cost of technology-enabled innovation and compliance across larger customer bases. This was frequently quoted as a near unstoppable driver of consolidation before the crisis.

I presume that it will be no less compelling post-crisis unless barriers are placed in the way of consolidation, innovation is somehow suppressed, or banks of limited scale find better ways to cooperate on innovation and technology with peers in other markets without having to merge to achieve this.


Thank you. You are helping to confirm my suspicion that this comprises both business model and policy questions that might be susceptible to empirical resolution – though not by me! I see that consolidation and innovation have gone hand in hand, but I’m not sure that consumers have benefitted as they should have. In fact I think they have been subject to overcharging, mis-selling and enforced docility that have reaped super-normal profits for the banks. Since I am not a Luddite I quite favour your idea about encouraging/requiring “banks of limited scale [to] find better ways to cooperate on innovation and technology with peers in other markets without having to merge to achieve this”.

It seems to address the scale (TBTF) and innovation issues.

@Karl W – I didn’t think I’d get away with a comment like that under your watch! lol.

my initial and ongoing view has always been that banks that are not viable should shut down – in particular Anglo, we only should have saved banks that were the very infrastructure of banking.

the things I said about the bankers getting out with golden handshakes and the ongoing cost has all been shown to be fairly correct.

the pro-NAMA stance – which I still maintain – came about when the government started to get involved and give certain, and distinct promises to the market, once made they must be fulfilled. Confidence hinged on a state promise, one that you can’t turn away from once made.

Which is why the 46, and anybody else wasn’t going to make a damn bit of difference – even if you are right, its a bitter pill i suppose but that’s life.

This is also mixed with a powerful banking lobby where they have convinced the state not to allow any bank to be left behind, and a state without the mettle to do the right thing, in fact, removing their ability to do the right thing via a universal guarantee- hence 2009 was a great year for bank-shares! (every dark cloud etc).

in short, i don’t support taxpayer bailouts, but when our state decides to underwrite the banks via the taxpayer then i do because we are pushed into honouring a promise made with or without our consent and that promise is what keeps the broken machine afloat.

I thought the soundbite “too big to fail means they are just too big” was one of the very few nuggets of sense to emerge in the past couple of years.

Granted, this financial crisis has only just begun to unfold and has some way to run.

But usually, painfull lessons are learned and then forgotten over decades resulting in the next crisis.

It’s ironic that the only progress we seem to be making is in forgetting the lessons more quickly.

As others (eg Buiter) are now saying: too big to fail has now become too big to save. Fiscal capacity to mount another serious bailout is now roughly zero. Sovereign default will be the issue over the next few years.

Alan Blinder, former Fed vice chair, writes in the Wall Street Journal today: “My fear is that a once-in-a-lifetime opportunity to build a sturdier and safer financial system is slipping away. Let’s remember what happened to health-care reform (a success story!) as it meandered toward 60 votes in the Senate. The world’s greatest deliberative body turned into a bizarre bazaar in which senators took turns holding the bill hostage to their pet cause (or favorite state). With zero Republican support, every one of the 60 members of the Democratic caucus held an effective veto—and several used it.
If financial reform receives the same treatment, we are in deep trouble, both politically and substantively.”

When Greed Is Not Good

So having a filibuster proof majority can also be a problem!

It is also interesting how the various monopoly commissions in the various countries have no problems with the monopoly profits being made by the too big to fail investment banks and the like. The injustice of all this is surely going to cause political ructions. Geithner and Obama are part of the problem, not the solution.

In short:

Utility banking (which cannot be allowed to fail) has been used as a base to leverage investment banking (which can and should be allowed to fail).

Break the link between utility banking and investment banking and we’re sorted.

Utility banking should be easy enough to regulate. Electricity supply might not be the best example of successful regulation of utilities, but it seems like the regulators are at least capable of ensuring that consumers aren’t completely ripped off by the dominating suppliers. Therefore I believe that consolidation of utility banking wouldn’t necessarily result in a bad thing.

I think I agree with Eoin in that complicated legislation will not work. Complex legislation leads to holes in the legislation and the incentives for the bankers to find and exploit the holes will be too great. The legislators would never keep up in trying to plug the holes.


That is the tricky bit & should be debated.

Currently I’d say the Irish collapse would be due to the lending to the developers.

The utility banking should (my personal opinion) be more focused on ability to repay than the value of the underlying security.
The lending to developers seems to have been much more focused on the value of the underlying security. The value of the security has shown to be less than anticipated and the developers ability to repay is…….

Therefore I believe the current collapse about the developers inability to repay.

Btw, the only thing I can think of to separate investment loan from utility loan is: If the borrower is using the security that the loan is for, then it is utility loan. If the borrower is trading in the security the loan is for then it is an investment loan. This is also very debatable, then again I believe that is part of what this forum is for 🙂

Define Democracy:

Where a decreasing number of growing corporations can heavily influance public policy, to the point where they know they can make risks that may result in their insolvency and yet will still have no effect on their viability. this is because the general population will hand over x billion of future earnings until they are solvent again. The only thing that can effect their viability are larger corporations.

Its called corporate capitalism.

Good answer!

I would argue that it becomes investment banking when the same banks are funding both sides of the game… they are funding developers to build and funding buyers to buy from them (whether for PPR or investment). The developers are bigger, in terms of loans outstanding, so there is an incentive set up for the banks to not do due diligence on behalf of small individual borrowers, because it benefits their large borrowers. With banks also taking equity stakes in developments, that incentive becomes over-whelming.

@Karl Whelan
The important point to remember about the blanket guarantee is that it was a piece of legislation. As our democratically elected parliament debated it we were told by the Minister for Finance from early Sept 09:

“Our banks uniquely have weathered this storm . . . We are in a zone of financial stability in a very troubled financial world.”? Two weeks later, having been panicked into his catastrophic bank liability guarantee, the Minister assured us that we had “the cheapest bailout in the world so far”, and six weeks later averred that: “It is not the function of the Government to fund or bail out the banks.”

But now we know that from early 2007 the government knew at least one of the banks were in trouble.

Our public, from whom all sovereignty is derived, (and their representatives, who are their employees,) wasn’t given the full facts – in fact were deliberately mislead – at the time of the guarantee. They are still being deliberately mislead. The blanket guarantee must be repealed. If a government had mislead a private company like this when signing a contract any court would tear up the contract, and award massive damages to the private company.

Misleading the public is hugely, massively more serious than misleading a private company, but the outcome should be the same. The blanket bank guarantee must be torn up.

Repealing the blanket guarantee is now a moral, political and economic imperative.

@Karl Deeter
‘too big to fail’? must therefore mean appropriate insurance cover and premium related to the risk:return profile of the banking business being undertaken – central bank underwriters to assess and accept/reject – premium to be paid by bank if accepted and reassessed on a continuous basis’
Is that what you were referring to?


The cynic in me were wondering if the banks were considering lowering their standards to spread the risk from the investment loan to the developer to the utility loan for a home owner.

The options for them were either to wait for better quality buyers/borrowers or deciding that 200 (pick a number here, that’s what I did) moderate to high risk borrowers are better to have than 1 large developer with high (some might say extremely high) risk loan. NAMA might have stopped that from happening for now….

Does anyone here have the definition of investment bank from the Glass-Steagal? Would AIB, BOI or Anglo have qualified as investment bank or retail bank?

@simpleton: absolutely. Thanks to the banks and those who should have been regulating them we are heading into very dangerous waters worldwide. In a way it would be astonishing if there were not a wave of defaults in the next few years.

@vinny that isn’t the exact point I was making but it is one that I would be in broad agreement with, our deposit guarantee fund only had 527m in it in 2008 – not enough to fix even one bank. banks got a free ride in terms of cost of insurance (because if the 527 ran out the rest was always going to be born by the taxpayer- which is no more than a transfer) and in future I think they do need to pay for it – oddly taxpayers will still pay for it via increased borrowing costs! Better again would be to have the market provide a few solutions – such as banks that are bangers closing down (not nationalised and kept on life support compliments of the taxpayer… closed and sold off), instead the state gave blanket guarantees they couldn’t renege on and investors walked away with a ten-bagger the sole loser has been the taxpayer, it’s wrong.

“Does anyone here have the definition of investment bank from the Glass-Steagal? Would AIB, BOI or Anglo have qualified as investment bank or retail bank?”
It seems to be unclear what an investment bank is, but there are a couple of other important bits of Glass-Steagall that would have had a big impact, I believe. In the first place, the separation of banking and insurance. Without being able to sell insurance, commercial banks would have been only buyers of CDS, not sellers.
In terms of investment banks, I don’t believe that banks would have been able to buy complex financial instruments. Not really a problem in Irish banks, but a help in some european ones?

All Irish banks would be largely commercial, with only small investing bits. We don’t know yet that the investing bits have lost vast amounts of money… given the relative size of its derivative book, Anglo was probably closest to an investment bank? Although some of the treasury operations at BoI and AIB must be quite substantial too?



I’m trying to understand how the regulator could have stopped this. Can’t say that I have understood it yet. I might be wrong and I don’t mind being corrected so:

The Irish banks were taking risks that turned out to be excessive (should be able to conclude this by their results?). The regulator (central bank?) could have told them that the risks were excessive? But the banks could have answered: “We follow the law, stop trying to tell us how to do our business.”

Glass-Steagal might not have stopped the Irish banks from getting into trouble. What kind of law/regulation would have stopped them without having the banks cry foul?

Sticking to existing borrowing/lending regulations would have helped. At the very least, massive numbers of the population would not have been approved for credit they can’t afford. This would have reduced the excesses in the economy and precipitated the crisis sooner, but at a smaller level.

My own view is heading for the idea that the major developers were bust in 2002, that a correction was about to take place, and that there was a conscious decision to loosen credit standards, increase tax allowances for property and inflate a property bubble (or rather, to pump more air into the existing property bubble).

But 100+% mortgages, 100% allowances for investors, mortgage interest relief, self-certified mortgages, the move from income multiples to ‘affordability’ criteria etc. etc. vastly loosened credit standards, the requirements for business plans (e.g. from investors) and the whole prudential aspect of lending. Anyone could qualify for credit, so all banks were concerned with was growing market share…

Aside from this, the regulator could have required larger loan losses, higher capital ratios etc.

This was within the power of both the regulator and the government to do something about. The idea that central bank interest rates are the only method of restricting house prices is nonsense, IMO; it is an attempt to absolve oneself from responsibility – not only did nobody not see it coming, but even if we did it’s not our fault, we could have done nothing – lies, damn lies, and what the government says…

What would peoples opinion be on some up to date anti property bubble legistlation?
Something like ‘A citizen may only borrow x times their Salary and must have at least x% of the value of the home for a downpayment yadda yadda yadda…’
I know it would impact on growth in the good times but perhaps its not the type of growth the economy needs anyhow.


I believe (although it is impossible for an outsider to verify) that all the regulations were followed. Maybe it is being verified now? There seems to be plenty of reasons to do so 🙂

It seems like they just made bad decisions in approving the credit. If that is the case, then we’re in trouble as it is impossible to legislate against poor judgement

Of course there might have been a regulatory failure. To me the failure could be in two parts:
1. The body monitoring the banks verified that laws were being followed but either they noticed that excessive risks were being taken and were powerless to stop it or they didn’t notice that excessive risks were being taken.
2. The body monitoring the banks noticed and also raised the issue with the legislators but the legislators didn’t listen.

So, I’m wondering:
1. Did the monitoring bodies notice the excessive risk?
2. Are the current legislation minimising the risk for the state?
3. Who are the monitoring bodies? The board of directors, internal auditors, external auditors, government representatives? If any, what are their respective failures?

My answers (personal opinion):
1. Should have noticed. Very unlikely they could have influenced the legislators to change the laws to stop what was happening.
2. No, the current legislation is not sufficient. New is needed. The question is which legislation?
3. Internal auditors verified if processes were being followed. I think it is likely the processes were being followed. External auditors, probably the same answer. Government representatives verified if laws were followed, the laws were probably being followed. The board of directors…… Should have etablished goals for the organisation & should have balanced risk & reward. Should have arranged for processes that supported the risk & reward structure that was decided by the board as representatives for the owners. The board of directors failed the most.

And a small observation: Bondbuyers seems to be able to demand a lot from states that are selling bonds, otherwise they won’t provide the cash. If they had put the same level of demand on the Irish banks before agreeing to buy their bonds then maybe the Irish bank crisis wouldn’t be so bad…..


Interesting idea.

In essence it will be personal freedom (to make good/bad economic choices without state interference) versus the level of protection to be given/had by the state.

I believe in times like these it might be possible to push it through, in bubble times there will not be a single politician arguing for it.

I also suppose the workability would depend on how the compromise between freedom and protection would look.

The concept of ‘moral hazard’ has not been aired in this chat.
Surely if the State, acting on behalf of its citizens, is expected to be a lender of last resort – then that facility must be fully paid for by the original lenders in the form of insurance premiums based on perceived underwriting risks?


There are many proponents of the insurance scheme. My opinion is if insurance schemes are introduced the crashes will happen more often.

My reasoning is:
The insured get to keep the profits.
The insured is indemnified from losses.
->Competition for profits will push down the price of risk to a level that will be to low.
->Many companies will take too big risks and the insurance company cannot cover them. -> State intervention again…..

The only way it could work is if, unlike AIG who failed miserably, the insurer can price the risk correctly. Anyone that good at pricing risk would do better (more bonus/more profit) at/as a bank issuing loans so even if that situation ever were to happen then I believe it will be very temporary.

Good point on Moral Hazzard vinney.

I find the idea that should accept that certain private enterprises (banks) should be allowed to make profits but not be allowed to fail as the biggest moral hazzard.

You might as well nationalise the entire financial industry!

Talk of insuring against failure doesnt make much sence in a globalised world where there is a likelyhood that insurance will be called upon by so many institutions at the same time that the insurer cannot pay. Wasnt that what caused the most problems for AIG?

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