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Too Big To Fail: The Hazards of Bank Bailouts

2007 Annual Report: Excerpts from the 2004 book by Gary H. Stern and Ron J. Feldman.

May 1, 2008


Gary H. Stern Former President (1985 - 2009)
Ron J. Feldman Senior Vice President
Too Big To Fail: The Hazards of Bank Bailouts

Editor’s Note: The essay in this Annual Report explains the authors’ policy recommendations in light of the 2007-08 financial turmoil. This excerpt, from the book’s introduction, summarizes the authors’ main messages and contrasts their approach with some alternatives.

Despite some progress, our central warning is that not enough has been done to reduce creditors’ expectations of TBTF protection. Many of the existing pledges and policies meant to convince creditors that they will bear market losses when large banks fail are not credible and therefore are ineffective. Blanket pledges not to bail out creditors are not credible because they do not address the factors that motivate policymakers to protect uninsured bank creditors in the first place. The primary reason why policymakers bail out creditors of large banks is to reduce the chance that the failure of a large bank in which creditors take large losses will lead other banks to fail or capital markets to cease working efficiently.

Too Big To Fail Book Cover Other factors may also motivate governments to protect uninsured creditors at large banks. Policymakers may provide protection because doing so benefits them personally, by advancing their career, for example. Incompetent central planning may also drive some bailouts. Although these factors receive some of our attention and are addressed by some of our reforms, we think they are less important than the motivation to dampen the effect of a large bank failure on financial stability.

Despite the lack of definitive evidence on the moral hazard costs and benefits of increased stability generated by TBTF protection, the empirical and anecdotal data, analysis, and our general impression—imperfect as they are—suggest that TBTF protection imposes net costs. We also argue that the TBTF problem has grown in severity. Reasons for this increase include growth in the size of the largest banks, greater concentration of banking system assets in large banks, the greater complexity of bank operations, and, finally, several trends in policy including a spate of recent bailouts.

Our views are held by some, but other respected analysts come to different conclusions. Some observers believe that the net costs of TBTF protection have been overstated, while others note that some large financial firms have failed without their uninsured creditors being protected from losses. However, even analysts who weigh the costs and benefits differently than we do have reason to support many of our reforms. Some of our recommendations, for example, make policymakers less likely to provide TBTF protection and address moral hazard precisely by reducing the threat of instability. Moreover, our review of cases where bailouts were not forthcoming suggests that policymakers are, in fact, motivated by the factors we cite and that our reforms would push policy in the right direction.

A second camp believes that TBTF protection could impose net costs in theory, but in practice legal regimes in the United States—which other developed countries could adopt—make delivery of TBTF protection so difficult as to virtually eliminate the TBTF problem.

We are sympathetic to the general and as yet untested approach taken by U.S. policymakers and recognize that it may have made a dent in TBTF expectations. In the long run, however, we predict that the system will not significantly reduce the probability that creditors of TBTF banks will receive bailouts. The U.S. approach to too big to fail continues to lack credibility.

Finally, a third camp also recognizes that TBTF protection could impose net costs but believes that there is no realistic solution. This camp argues that policymakers cannot credibly commit to imposing losses on the creditors of TBTF banks. The best governments can do, in their view, is accept the net costs of TBTF, albeit with perhaps more resources devoted to supervision and regulation and with greater ambiguity about precisely which institutions and which creditors could receive ex post TBTF support.

Like the third camp, we believe that policymakers face significant challenges in credibly putting creditors of important banks at risk of loss. A TBTF policy based on assertions of “no bailouts ever” will certainly be breached. Moreover, we doubt that any single policy change will dramatically reduce expected protection. But fundamentally we part company with this third camp. Policymakers can enact a series of reforms that reduce expectations of bailouts for many creditors at many institutions. Just as policymakers in many countries established expectations of low inflation when few thought it was possible, so too can they put creditors who now expect protection at greater risk of loss.

The first steps for credibly putting creditors of important financial institutions at risk of loss have little to do with too big to fail per se. Where needed, countries should create or reinforce the rule of law, property rights, and the integrity of public institutions. Incorporating the costs of too big to fail into the policymaking process is another important reform underpinning effective management of TBTF expectations. Appointment of leaders who are loath to, or at least quite cautious about, providing TBTF bailouts is also a conceptually simple but potentially helpful step. Better public accounting for TBTF costs and concern about the disposition of policymakers could restrain the personal motivations that might encourage TBTF protection.

With the basics in place, policymakers can take on TBTF expectations more credibly by directly addressing their fear of instability. We recommend a number of options in this regard. One class of reforms tries to reduce the likelihood that the failure of one bank will spill over to another or to reduce the uncertainty that policymakers face when confronted with a large failing bank. These reforms include, among other options, simulating large bank failures and supervisory responses to them, addressing the concentration of payment system activity in a few banks, and clarifying the legal and regulatory framework to be applied when a large bank fails.

Other types of reforms include reducing the losses imposed by bank failure in the first place and maintaining reforms that reduce the exposure between banks that is created by payments system activities. These policies can be effective, in our view, in convincing public policymakers that, if they refrain from a bailout, spillover effects will be manageable. Such policies therefore encourage creditors to view themselves at risk of loss and thus improve market discipline of erstwhile TBTF institutions.

We are less positive about other reforms. A series of reforms that effectively punish policymakers who provide bailouts potentially also could address personal motivational factors. However, we are not convinced that these reforms are workable and believe that they give too much credence to personal motivations as a factor to explain bailouts. The establishment of a basic level of supervision and regulation (S&R) of banks should help to restrict risk-taking, although we view S&R as having important limitations.

Finally, policymakers have a host of other available options once they have begun to address too big to fail more effectively. For example, policymakers could make greater use of discipline by creditors at risk of loss. Bank supervisors could rely more heavily on market signals in their assessment of bank risk-taking. Deposit insurers could use similar signals to set their premiums.

Editor’s Note: This excerpt, from the book’s conclusion, recaps the key points from the book and offers some more details about the authors’ proposals.

Three Bottom Lines

First, the TBTF problem has not been solved, is getting worse, and leads, on balance, to wasted resources.

Second, although expectations of bailouts by uninsured creditors at large banks cannot be eliminated, they can be reduced and better managed through a credible commitment to impose losses. Policymakers can establish credible commitments by addressing and reducing the motivation for bailouts.

Third, although other reforms could help to establish a credible commitment, policymakers should give highest priority to reforms limiting the chance that one bank’s failure will threaten the solvency of other banks.

We now provide supporting points for these conclusions.

The Problem

—Even though they are not entitled to government protection, uninsured creditors of a large or systemically important bank believe they will be shielded from at least part of the loss in the event of bank failure.

—Anticipation of government protection warps the amount and pricing of funding that creditors provide a TBTF bank, which, in turn, leads banks to take excessive risk and make poor use of financial capital. The costs of poor resource use resulting from TBTF guarantees appear to be quite high. We believe these costs exceed the benefits of TBTF coverage in most cases, but even those who weigh the costs and benefits differently should be able to support many of our reforms.

—Expectations of TBTF coverage have likely grown and become more strongly held because more banks are now “large” and because a smaller group of banks controls a greater share of banking assets and provides key banking services. In addition, banks have become increasingly complex, making it more difficult for policymakers to predict the fallout from bank failure and to refuse to provide subsequent coverage to uninsured creditors.

—Reforms over the last decade aiming to limit TBTF protection, including those adopted in the United States, are unlikely to be effective in the long run (although they have yet to be tested and may have made a dent in TBTF expectations).

Commitment as the Solution

—In order to change the expectations of bailouts, policymakers must convince uninsured creditors that they will bear losses when large banks fail; changes in policy toward the uninsured must involve a credible commitment.

—A credible commitment to impose losses must be built on reforms directly reducing the incentives that lead policymakers to bail out uninsured creditors.

—Reforms that forbid coverage for the uninsured are not credible because they do not address underlying motivations and are easily circumvented.

—Policymakers have considerable experience in establishing credible commitments in the setting of monetary policy. The experience of monetary policy over the last two decades demonstrates the feasibility of reducing long-held expectations, such as those likely held by uninsured creditors of large banks.

Specific Motivations and Reforms

—The most important motivation for bailouts is to prevent the failure of one bank from threatening other banks, the financial sector, and overall economic performance. To reduce that motivation, we recommend that policymakers in developed countries take three general steps: enact policies and procedures that would reduce their uncertainty about the potential for spillovers; implement policies that directly limit creditor losses or allocate losses such that market discipline increases without an excessive increase in instability; and consider or follow up on payment system reforms that reduce the threat of spillovers.

—Reforms that reduce policymaker uncertainty include the following: increase supervisory planning for, and simulation of, a large bank failure; undertake targeted efforts that reduce the likelihood and cost of failure for banks dominating payment markets; make legal and regulatory adjustments that clarify the treatment of bank creditors at failure; and provide liquidity more rapidly to uninsured creditors.

—Reforms that could address concerns of excessive creditor loss include the following: close institutions before they can impose large losses; require banks in a weak position to increase the financial cushion to absorb losses; impose rules that require creditors to absorb at least some loss when their bank fails (for example, requiring coinsurance); and allow for select coverage of the nominally uninsured while, in general, making it more likely that creditors will suffer losses.

—Although payment system reforms are quite complex in implementation, they are fairly straightforward in concept. One type of reform would eliminate or significantly limit the amount that banks owe each other through the payment system. A second type of reform would establish methods by which a bank owed funds by a failing institution could offset losses (for example, by seizing collateral).

Excerpts are reprinted, with permission, from Too Big To Fail: The Hazards of Bank Bailouts, Gary H. Stern and Ron J. Feldman, Washington D.C.: Brookings Institution Press, 2004.