Who is 'too big to fail'?

When the financial crisis struck last year, US federal regulators pumped tens of billions of dollars into leading financial institutions because the banks were so big that their failure might have brought down the entire financial system.

Following this, the chairman of the US House Financial Services Committee introduced a new 300-page long bill last week aimed at tackling the problem of what to do about 'too big to fail' financial firms, and strengthening the Government's ability to deal with those that are on the brink of collapse.
 
The bill, drafted with the Treasury Department, would give the Federal Reserve authority to take over firms that are at risk of failing and therefore present a danger to the broader economy. It would allow the Government to dismantle a company without sending it through a standard bankruptcy.
 
In spite of the scope of the proposals, some are saying that the bill does not address all of the key points:

• The bill does not answer perhaps the most obvious – and one of the most difficult – questions: Who, exactly, is too big to fail? Which are the organisations that pose such a systemic risk to the entire financial system that they hitherto have been saved at all cost? This became a key question last year, when Lehman Brothers, the large investment bank, was allowed to collapse, triggering panic in the financial markets.
• There will not be full market discipline – the markets do not believe that the Government will actually let a firm like Citigroup, Goldman Sachs go out of business.
• Although the Financial Services Committee is saying that these banks will be allowed to go under, these are firms that have actually got bigger. JP Morgan Chase now holds more than $1 of every $10 on deposit in the US, as do Bank of America and Wells Fargo. It seems unlikely that these behemoths would be allowed to collapse.
• One of the goals of this legislation is to make sure that in the future these financial giants are allowed to fail if they must but that the costs are borne by the financial firms themselves and not taxpayers. The money for that would come from other financial firms, specifically the largest banks, those with at least $10bn in assets – a category that includes roughly 120 US banks. This raises questions such as: Which companies will have to pay for the collapse of one of their competitors? And how easy will it actually be to obtain funding from those other financial institutions during a financial crisis?

It is likely that these proposals, however positive, will encounter some serious controversy before too long.