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"Too big to fail": rationale, consequences, and alternatives.

The "Too Big to Fail" (TBTF) doctrine was formalized in light of the liquidity crisis at Continental Illinois Bank in 1984. The objective of this policy is to preserve public confidence in banking institutions and thereby avoid the systemic problems associated with large bank failures. This article reviews the history of the TBTF policy, critically appraises its rationale and success, and discusses the serious economic consequences associted with TBTF. The moral hazard problems arising from the combination of TBTF, lax capital standards and a flat rate system of deposit insurance are examined. Alternatives to TBTF are suggested.

IN THE WAKE of the Continental Illinois bank liquidity crisis, the Comptroller of the Currency testified to Congress on September 19, 1984, that some banks were just "too big to fail" (TBTF), and in these cases total deposit insurance protection would be provided, rather than enforcing the statutory $100,000 per account limit. In his testimony, the Comptroller admitted that banks included in the TBTF policy were the eleven largest. The next day, the Wall Street Journal identified these banks as BankAmerica, Bankers Trust, Chase Manhattan, Chemical Bank, Citibank, Continental Illinois, First Chicago, J. P. Morgan, Manufacturers Hanover Trust, Security Pacific, and Wells Fargo.(1)

The implementation of the TBTF policy has raised questions regarding its fairness. For example, during the second half of 1990, the Freedom National Bank, located in Harlem, failed. The FDIC was unsuccessful in locating a buyer and therefore paid off as many depositors as possible up to the limits of deposit insurance. Once failure was imminent, depositors had little time to move their funds to a safer institution. A few months earlier, the National Bank of Washington failed. In that case, however, the FDIC arranged for Riggs National Bank to assume all of the bank's deposit liabilities. Depositors incurred no losses. Disparities such as these have tended to divert the focus of the debate on TBTF from the more important issues related to its economic consequences and necessity to the more emotional issue of fairness to depositors of large versus small banks.


From the time of the stock market crash in the fall of 1929 through the end of 1993, almost half (or nearly 9,000) of the total number of commercial banks in the U.S. failed or otherwise suspended operations. Faced with a growing sense of panic regarding the stability of the banking system, Congress passed and President Roosevelt signed the Banking Act of 1993, which created the Federal Deposit Insurance Corporation (FDIC) and a "temporary" deposit insurance fund. Coverage limits were initially set at $2,500, but were soon increased to $5,000. The FDIC was a huge success in its early years, restoring consumer confidence in the banking system and drastically reducing the rate of bank failures. Between 1934 and 1939, the average number of bank failures was only sixty per year, and the total cost of these failures was about $18 million.(2) From 1940 to 1980, bank failures averaged only four per year. For every year between 1935 and 1987, income from premiums and investments was greater than the fund's expenditures for bank failures. However, the era of banking stability ended in the decade of the 180s. During that time, approximately 700 commercial banks with total assets approaching $170 billion failed or were restructured with FDIC assistance. Limits for deposit insurance coverage were increased from $25,000 to $100,000 in 1980. By the end of the decade, the FDIC fund was effectively broke.(3)

Between 1950 and 1982, the Federal Deposit Insurance Act permitted the FDIC to invoke an "essentiality" concept when deciding whether to let a bank fail or not. This concept can be applied in those cases "in which the corporation determines that the continued operation of such insured depository institution is essential to provide adequate depository services in the community."(4) The first application of the essentiality concept occurred in 1971 when the minority-owned Unity Bank of Boston was bailed out under this doctrine, even though there was evidence of mismanagement. Shortly thereafter, the Bank of the Commonwealth, a large, poorly managed Detroit institution was bailed out under similar circumstances.(5)

Legally, the FDIC has an obligation to protect depositors up to the limits of deposit insurance. Since the passage of the Garn-St. Germain Act in 1982, the FDIC has had the authority to use "purchase and assumption" transactions as an alternative to liquidation, if the former has a lower cost. Over the ten-year period ending in 1989, the FDIC actually protected 99.7 pecent of all deposit liabilities for failed banks.(6) Thus the FDIC has provided nearly 100 percent deposit insurance coverage. The primary exceptions to this rule have been large (over $100,0000) depositors in smaller banks.

A look at some early, large bank failures provides insight regarding the actions of banking regulators when dealing with large failed institutions. For example, Franklin National Bank, the twentieth largest bank in the United States in 1973, failed in 1974. This bank failure proved to be a major test for the integrity of the financial marketplace and the ability of regulators to control the damage asociated with such a major bank collapse. A policy of rapid growth in the 1960s through high-risk, often long-term loans (funded with short-term deposits), long-term bond investments during a period of rising interest rates, and finally aggressive speculation in the foreign currency market led to huge losses. In May 1974 the bank publicly acknowledged its problems and cancelled its common stock dividend. Deposits declined from $3.7 billion at year-end 1973 to $3.2 billion in May, as large uninsured depositors moved their funds to more secure institutions. Six weeks later deposits had declined to $2.1 billion, and finally to $1.4 billion on October 8, 1974, the date the bank was declared insolvent and merged into the European-American Bank. During the period of depositor runs on the bank, the Federal Reserve Bank announced a policy of making discount loans available to the bank so that depositors would not suffer losses. By October, the Federal Reserve had lent Franklin nearly $1.75 billion. This action protected from failure other banks having significant outstanding transaction relationships with Franklin, both in the U.S. and abroad.

The Penn Square Bank of Oklahoma is a case of a medium-sized bank that was permitted to fail. In July 1982 the FDIC permitted Penn Square Bank of Oklahoma, an aggressive energy lender with total assets over $500 million, to fail under the payout option. Uninsured depositors and other creditors received approximately 60 cents on the dollar. The bank had grown rapidly by making high-risk loans in the oil and gas industries. Because loan demand exceeded the bank's funding ability, Penn Square sold participations in these loans to banks like Continental Illinois Bank and Seattle-First National Bank (Seafirst). Continental alone had purchased over $1 billion of these loans. As we shall see below, the Penn Square failure had devastating consequences on other, larger banks, including Continental Illinois Bank.

When oil prices declined in the early 1980s, a significant number of energy industry borrowers, including many of those who had loans that were originated by the Penn Square Bank and had been sold to Continental Illinois, defaulted. By December 1982 Continental had written off or listed as nonperforming assets over $500 million of its loan participations with Penn Square. Conditions continued to deteriorate for Continental, and by May 1984 rumors spread about Continental's weak condition and the possibility of a takeover. A run on the bank ensued and the bank found that its traditional sources of funding were no longer accessible. To meet these outflows, Continental borrowed over $4 billion from the Federal Reserve and arranged an additional $4.5 billion line of credit from sixteen large banks. However, these actions failed to halt the depositor run. To prevent the bank from failing and to calm the capital markets, the FDIC, for the first time, guaranteed payment to all of the bank's depositors (including those with deposits in excess of FDIC coverage limits) and to the bank's other general creditors. In July the FDIC purchased $3 billion of Continental's troubled loans, purchased $1 billion of preferred stock that could be converted into 80 percent of the firm's common stock, effectively took control of the bank, and replaced its top management. In September 1984, the Comptroller of the Currency formally announced the TBTF policy.

It is interesting to note that the TBTF doctrine is not unique to the banking industry. In 1971, Lockheed's L-1011 Tri-Star commercial jet program was rescued by a $250 million government loan guarantee for funds needed to complete development of the plane. The justifications given for these guarantees included Lockheed's status as a large and important defense contractor and the desirability of increasing competition in the commercial airframe industry. Similarly, when Chrysler teetered near bankruptcy, the firm sought and received $1.2 billion of U.S. government loan guarantees, which had the effect of lowering its financing costs while it tried to resolve its operating and financing difficulties. The arguments made in support of the Chrysler loan guarantees included a desire to avoid the negative employment impacts associated with a Chrysler failure and a desire to maintain competition in the domestic automobile industry. In both the Chrysler and the Lockheed cases, the affected companies ultimately survived their operating and financial difficulties and emerged as viable, although somewhat weakened firms. Furthermore, in both cases stockholders retained a significant ownership interest in the firm.

In contrast, the TBTF doctrine in the banking industry is somewhat of a misnomer. In all significant cases when the doctrine has been invoked since the Continental Illinois crisis, the affected financial institution did, in fact, fail. Shareholders received nothing in these transactions. Rather than "Too Big to Fail," the policy that has been applied by the FDIC can better be described as "Too Many Big Depositors to Ignore."


It has been argued the TBTF policy in banking is necessary because:

1. Potentially, major "systemic" problems can arise when a large uninsured bank fails, leaving some depositors and other creditors unprotected. Without a TBTF policy it is feared that uninsured depositors will withdraw funds rapidly from banks in questionable condition, thereby accelerating the problems facing these banks and perhaps spilling over to other weakened but viable banks and forcing their demise. Rapid reallocations of deposits in the banking system also have undersirable consequences for the extension and maintenance of credit. The systemic problem arguments for TBTF are discussed in more detail below.

2. bank regulators have a difficult time determining in a timely manner which banks are viable and which need to be liquidated, once a run on a bank begins.

3. A considerable amount of time is required to arrange for the sale of liquidation of a large bank. These time lags provide large, uninsured depositors the opportunity to move their funds to safer institutions. Thus, unless one is willing to close large banks at the first sign of trouble, and thereby incur the large and often unnecessary expenses of liquidation, it is unlikely that uninsured deposits will remain by the time a determination of nonviability is made.(7)

The prevention of systemic risks that can overwhelm the banking and financial system is the primary argument made in support of the TBTF doctrine. Systemic risks include "potential spillover effects leading to widespread depositor runs, impairment of public confidence in the broader financial system, or serious disruptions in domestic and international payment and settlement systems."(8) These systemic risks were evident in the failures of Continental Illinois and Seafirst, triggered in large part by the failure of the Penn Square Bank.(9)

The failure of a very large bank could impair the payment system among individuals and banks to a sufficient degree to have a noticeable impact on the nation's level of economic activity. Large banks are typically providers of correspondent banking services to smaller banks. Part or all of the compensation received by the larger bank is in the form of compensating balances held by the smaller banks at the correspondent bank. Failure of one of these larger banks can cause a ripple effect of liquidity and solvency problems for the smaller banks. Furthermore, if a major correspondent bank fails, clearing and settlement problems could develop for customers of other banks that depend, in some way, on the services of the correspondent bank.

One of the major sources of systemic risks relates to foreign exchange contracts. Foreign exchange contracts typically are settled two days hence for spot market transactions. If one of the parties fails during this settlement period, counterparties would be exposed to substantial losses on their transactions should exchange rates move unfavorably. A greater risk arises because of the practice of paying foreign currencies in settlement of foreign exchange contracts before the completion of counterpayments in U.S. dollars. Hence, U.S. and foreign banks face a temporary risk exposure equal to the full amount of the foreign currency that has been paid out prior to the receipt of dollars.

Another important source of systemic risk relates to the risk of depositor runs on banks if confidence in the banking system is shaken. These runs can affect both healthy and unhealthy banks and lead to significant short-run credit availability problems. Credit relationships are not readily transferrable from one institution to another, because the initial lending institution often possesses unique information about the borrower and has created the ability to monitor loan progress efficiently. A run on the deposits at one bank will lead to increased deposits at stronger banks, but it will be much more difficult for borrowers to move from one bank to another. Hence, it is argued that the TBTF doctrine also may be justified because a rapid shift of deposits from weak banks to stronger banks may have serious consequences for the creation and maintenance of credit relationships.

Another source of systemic risk associated with the failure of large banking organizations relates to the role these institutions play in the market for mortgage-backed securities, government securities and municipal securities. Large banks provide liquidity to many of these markets because the banks play the role of a marketmaker. Consequently, the sudden collapse of a large bank could temporarily damage the operation of these markets.

The avoidance of systemic risks associated with large bank failures have been used as the primary justification for TBTF. However, these avoided risks also have undersirable economic consequences, considered in the following section.


The concern by regulators over the systemic risk implications of bank failures must be juxtaposed with the economic consequences of the TBTF doctrine. Unfortunately for regulators, these consequences have conflicting policy implications, so that a discussion of TBTF must incorporate the deposit insurance environment. It is generally recognized that one of the major deficiencies of the existing deposit insurance system stems from the fact that deposit insurance "premiums" are levied on a flat-rate basis, i.e., premiums are based on the deposits of the bank. It is this risk-neutral system that may produce undesirable competitive, structural, and regulatory implications for the banking industry.

Generaly described as the "moral hazard" problem, the flat-rate system creates undesirable incentives for the management of banks as well as the depositors (both insured and uninsured). If the objective of the bank's management is to maximize the wealth of its stockholders, management clearly has an incentive to increase the risk of the bank's asset portfolio. The problem is that the increased risk is shared by all claimants to the bank's assets -- shareholders, depositors, and the FDIC -- but the potential rewards belong only to stockholders. When deposit insurance is not fully risk-sensitive, the bank's equity holders benefit if its risky investments pay off. But if the risky investments (primarily loans) default, stockholders lose only their capital investment and either depositors or the FDIC bears the brunt of the cost of failure. In essence, the current deposit insurance system provides a "deposit subsidy" to shareholders. TBTF, larger banks will have a greater incentive to increase risk and therefore realize a larger deposit subsidy.

The moral hazard issue also has implications for the structure of the banking industry. It follows that the moral hazard/deposit subsidy effects are exacerbated as a bank's net worth diminishes. The structural implication is that larger banks have an incentive to maintain lower capital-to-asset ratios than smaller banks. The asymmetric distribution of the deposit subsidy also impacts the behavior of depositors. In the current environment, depositors of large banks have little incentive to monitor the riskiness of banks. If the bank fails, the FDIC is obligated to protect small ($100,000 and under) depositors, and large depositors can rely on the FDIC to extend coverage in accordance with the TBTF doctrine. Thus, when a bank's asset risk increases, little risk-sharing occurs. In fact, under TBTF and risk-neutral deposit insurance, the risk is shifted from shareholders and depositors to the FDIC.

A TBTF policy also can have a negative effect on the economic efficiency of banking. The (uncontrollable) economic conditions in a particular banking market may be so severe as to cause a bank to be unprofitable and ultimately to fail. Such "bad luck" can result in the failure of both efficient and inefficient banking firms. The optimal system is one where regulators are able to determine which are the efficient banks, worthy of forbearance, and which are the inefficient banks that should be closed. The present TBTF system does not provide shareholders or depositors the incentive to force inefficient banks out of business. The TBTF policy actually fosters a situation analogous to the S&L industry crisis and could result in what Professor Edward Kane calls "zombie" banks.(10) Allowing zombie baks to continue in operation permits inefficient banks to compete aggressively with efficiently run banks for deposits and loans. For example, large depositors in TBTF banks become indifferent to the risks assumed by the bank, making the efficient banks less profitable and possibly more risky. The creation of zombie banks inevitably results in costs that all banks must share. Thus the TBTF policy, coupled with a risk-neutral deposit system, creates an incentive for banks to become large and risky.

Evidence of the Consequences of TBTF

Ample empirical evidence is available of the risk implications of the moral hazard problem and the impact of TBTF on depositor discipline. The precipitous fall in the capital-to-asset ratios of commercial banks from 8 percent in 1960 to 6 percent in 1985 indicates an overall increase in the risk of the banking system.(11) However, this average conceals variations that are suggested by the moral hazard problem, i.e., larger banks will use less equity to realize a larger deposit subsidy. At year-end 1989, the twenty-five largest U.S. banks had capital-to-asset ratios averaging only 4.8 percent,(12) and by mid-1990, 183 banks with assets over $11.3 billion had capital-to-asset ratios below 3 percent.(13)

The risk-seeking behavior implied by the deposit insurance-motivated moral hazard problem also is reflected in bank asset portfolios. The shrinking share of the blue-chip corporate customer has been replaced by higher-risk real-estate lending, loan commitments, and stand-by letters of credit. From 1985-1990, 65 percent of the increase in bank loans was in real estate, over 43 percent of this increase was in commercial real estate, and off-balance sheet activities increased from 58 percent of assets in 1982 to 116 percent in 1989.(14) Other evidence indicates that high loan losses by banks followed a period of high reported earnings. This increase in portfolio risk appears to spread throughout the loan portfolio -- banks with high losses in one portfolio also had high losses in other portfolios.(15)

The S&L "crisis" also supplies convincing support for the moral hazard problem. Several authors report that insolvent thrifts grew significantly faster than the average and that this growth was fueled by disproportionate investments in commercial mortgages, real-estate loans, direct equity investments, and other nontraditional assets.(16) Moreover, the evidence indicates that the risk of the asset portfolios and the reliance on "hot" money of failed thrifts were negatively related to the capital-to-asset ratio.(17) Clearly compelling evidence suggests a systematic pattern of risk-taking behavior consistent with the moral hazard problem.

It also is argued that TBTF diminishes the incentive for depositors to closely monitor and discipline ex-ante risky banks. Empirical evidence also supports this view. The strongest evidence is reported by studies examining the pricing structure of large certificates of deposit and subordinated debt of commercial banks. The evidence displays an absence of yield risk-premiums on commercial bank debt.(18) Researchers argue that a TBTF policy will lead to unfair competitive distortions between banks based on size and ultimately an inefficient credit allocation system.


The 1991 Deposit Insurance Reform Act has squarely addressed the TBTF issue. In essence, the new legislation mandates regulators to focus on the amount of capital instead of the amount of assets in determining closure policy. A sliding scale to rate banks based on their capital-to-asset ratios is established. Any bank with a capital-to-asset ratio less than 2 percent must be closed within ninety days. However, it remains to be seen whether this mandatory early intervention policy will resolve the problems inherent in TBTF. For example, how does this capital criterion prevent the closure of efficiently run banks that operate in economically depressed areas? Under this policy inefficient banks will fail, but the viability of some banking markets may be compromised if otherwise well-managed, but temporarily (due to economic factors) poor performing banks also are closed under the policy. Such a trade-off is not desirable.

This capital-based forbearance legislation possesses the same deficiency that has historically plagued capital adequacy guidelines -- lack of control over the risk of the asset portfolio. Who or what is responsible to control the risk-taking activities of the bank? Even under an early intervention system, the FDIC would be exposed to heavy losses due the risk of the asset portfolio. Accordingly, the most significant criticsm of the 1991 Act is that it relies too heavily on regulator discretion. The fear is that the political realities may result in regulators either becoming "heavy handed," taking excessive measures against banks that experience any reduction in capital, or maintaining the policy of TBTF and not downgrading the risk category of large banks.


Popular alternative approaches to the TBTF policy are coinsurance or deposit "haircuts," increased capital ratios, use of subordinated debt, and private insurance schemes. The basic premise underlying coinsurance approaches is that, unlike the present system, large depositors will have an incentive to monitor and signal to regulators, via yield premiums on debt, the perceived risk of the bank. The monitoring incentive arises from the potential loss of funds due to the "haircut" limit on deposit insurance coverage.

Substantially increased capital ratios would provide stockholders with an increased incentive to monitor and control the risk of the bank, and would afford regulators more time to uncover problems and take corrective action. Promoting the use of subordinated debt would help align the interests of stockholders, bondholders and regulators, leading to increased discipline by capital markets. A private deposit insurance system could be designed to work in tandem with a federal system. Private insurance creates the incentive for both the management and the insurer to monitor bank risk.

Each of these alternatives improves upon the current TBTF policy by providing incentives to capital markets to monitor and discipline banks based upon risk. Creating incentives for private monitoring would align the interests of regulators, stockholders, and large depositors and significantly reduce the moral hazard problem that arises with TBTF.


(1)Some confusion existed regarding the identification of the TBTF banks. Specifically, because the Comptroller has jurisdiction only over national banks, his reference to the eleven banks may have been restricted to the eleven largest national banks. This interpretation of the TBTF doctrine would add the following national banks to the list, replacing some of the larger state banks: Marine Midland, Bank of Boston, Mellon Bank, and Crocker National Bank.

(2)For more detail, see John L. Douglas, "Deposit Insurance Reform," Wake Forest Law Review, 27, no. 1, 1992, pp. 11-30. See also Federal Deposit Insurance Corporation, Federal Deposit Insurance Corporation: The First Fifty Years, (Washington, D.C.: 1984).

(3)A further discussion of this history can be found in Federal Deposit Insurance Corporation, 1989 Annual Report, (Washington, D.C.: 1989).

(4)12 U.S.C. Sections 1823 (c)(1) and (c)(4)(A) (1988).

(5)For a further discussion of the early history of bailouts under the essentiality doctrine, see Irvine H. Sprague, Bailout, (New York: Basic Books, 1986).

(6)Testimony of William Siedman, Chairman, FDIC, Oversight on the Condition of the Financial Services Industry, 1989: Hearing on S. 183 Before House Banking, Housing, [unkeyable] Urban Affairs Committee, 101st Congress, 1st Session 152 (1989).

(7)Richard E. Randall, "The Need to Protect Depositors of Large Banks, and the Implications for Bank Powers and Ownership." Federal Reserve Bank of Boston, New England Economic Review, September/October 1990, pp. 63-75.

(8)John P. LaWare, Member, Board of Governors of the Federal Reserve System, before the Subcommittee on Economic Stabilization of the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, May 9, 1991, Federal Reserve Bulletin, July 1991, p. 549.

(9)The initial systemic risk in the Penn Square case was related primarily to loan participations, not uninsured deposits, although the presence of uninsured deposits ultimately led to a run on the banks.

(10)Edward J. Kane, "Dangers of Capital Forbearance: The Case of the FSLIC and 'Zombie' S&Ls," Contemporary Policy Issues, Vol. 5, (January 1987), pp. 77-83.

(11)U.S. Department of Commerce. Statistical Abstract of the United States, Washington, D.C.: U.S.G.P.O., 1965 and 1985. Even more dramatic is the decline of the ratio of equity capital-to-risk assets. (Risk assets are a bank's total assets less cash and U.S. government securities.) The ratio of capital-to-risk assets declined from 15 percent in 1961 to 7.9 percent in 1988. (Source: FDIC Annual Reports, and Federal Reserve Bulletin, various issues.)

(12)U.S. Treasury, "Modernizing the Financial System," February 1991.

(13)James R. Barth, Dan Brumbaugh, Jr., and Robert Litan, "The Banking Industry in Turmoil: A Report on the Consolidation of the Banking Industry and the Bank Insurance Fund." Report to the Financial Institutions Subcommittee of the House Committee on Banking, Housing and Urban Affairs, 101st Congress, 2nd session, December 1990.

(14)Board of Governors of the Federal Reserve System, Federal Reserve Bulletin, Washington, D.C.: Board of Governors, December 1991, p. A36.

(15)William Keeton and Charles Morris, "Why Do Banks' Loan Losses Differ?" Federal Reserve Bank of Kansas City, Economic Review, May 1987, pp. 3-21.

(16)James R. Barth, Philip F. Bartholomew, and Michael G. Bradley, "The Determinants of the Thrift Resolution Costs," Research Paper, No. 89-03, Office of the Chief Economist, Office of Thrift Supervision, November 1989.

(17)Rebel Cole, J. McKenzie, Lawrence White, "Deregulation Gone Awry: Moral Hazard in the Savings and Loan Industry," Federal Reserve Bank of Dallas, Working Paper, March 1991.

(18)Gary Gorton and Anthony Santomero, "Market Discipline and Bank Subordinated Debt," Journal of Money, Credit, and Banking, Vol. 22, 1, 1990, pp. 119-128.
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Title Annotation:banking
Author:Moyer, R. Charles; Lamy, Robert E.
Publication:Business Economics
Date:Jul 1, 1992
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