Study on Too Big To Fail

The ‘Too big to fail’ hypothesis claims that some large financial corporations whose failure would be so disastrous to the economy. Big financial institutions benefit from the economies of scale as well as scope. This makes them more efficient as compared to small firms. Since a significant form has more diversity than a small firm, the more prominent firm then has a superior competitive position. Also, the big firm has reduced exposure to risks. Following this, it becomes hard for the economy’s structural changes to affect such a big company. The big firms also enjoy higher market powers, and they have less cost of capital. Following this, the government must interfere with any risks because such a big company’s failure may lead to severe economic effects. The essay will review some of the articles and books that have explained the concept of ‘too big to fail’. Also, this essay will explore some of the common examples of ‘too big to fail’ firms. Also, I will explain my research methodology, which includes defining the purpose of the study and hypotheses and methods to be adopted. Finally, I will conclude my essay by summarizing the key issues of the report.

Theoretical Background

Moosa explains that the ‘too big to fail’ is due to political power towards the financial institutions. Also, the doctrine resulted from the unbalanced relations that exist between the financial sector and society. According to Moosa (2010), the government has a strong influence on financial institutions. Following this, the government cannot allow a big financial institution to fall down because the country’s economy will be affected negatively. The article has explained the role of academia in the finance industry. The financial economist has come up with an efficient market hypothesis. Besides, other academics like macroeconomists have developed the defunct rational expectations hypothesis. Also, they have come up with a favorable macroeconomics policy that will benefit the financial sector. The article has also highlighted various arguments against TBTF, like using the money spent on bailouts for job creation, and there is no clear way of deciding which firm is worthy of TBTF (Moosa, 2010). The article is very informative, and the issues highlighted help understand the ‘Too big to fail concept.

In his article, Kaufman demonstrates that the concept of ‘too big to fail is very complex than it is perceived (Kaufman, 2014). This concept’s definition varies and is very important in banking institutions since it helps determine its benefits and costs. The author has explained the complexity involved in determining the complexity of the concept. It is hard to determine the institution that is too big to demand government assistance. Also, sometimes it is better to dissolve the bank instead of funding it since the problems that made it insolvent might recur after some time. This explains the reasons why regulators fear widespread financial instability in banking institutions. The article is important since it explains the complexity of the ‘too big to fail concept’. It also explains why the concept might not be as good as people think, as the financial implications that come after finding the big banking institutions also negatively affect the general society.

In his article ‘Too Big to Fail: Causes, Consequences, and Policy Responses’, Philip explains the causes, policy responses as well as consequences of the ‘Too Big to Fail’ concept. One reason why the government prefers bailouts for too big financial institutions is that the policymakers believe that the short-run benefits of bailing out exceed the long-run costs (Strahan, 2013). Another reason is that failure to bail out the large financial institutions can harm other financial firms, leading to an economic crisis. The article has also explained some strategies to mitigate the Too Big to Fail’ problem. Financial institutions should minimize spill over to the customers, the economy and the market. Another way is by creating a new resolution authority. This may include liquidating or closing the affected financial institution. The advantage of this article is that it gives new solutions that might help avoid the concept of too big to fail, especially if the tax payer’s money will be the one used to bring the company back.

Moosa wrote the book ‘The Myth of Too Big to Fail’ to explain how the doctrine affects the financial institution and the economy at large (Moosa, 2010). The book describes the issue of laissez-faire and how it relates to TBTF. The author gives a historical background of financial deregulations on how this led to the TBTF concept. In chapter three, there are examples of some rescue operations carried out to rescue some financial institutions. This includes continental Illinois, which was the eighth largest bank in 1984 (Moosa, 2010). The bank found itself in a financial crisis due to a faulty funding model. The government rescued the banker through the ‘Too Big to Fail’ concept. However, Fernand St Germain said he was not happy with the bank’s bail since it was costly.

Another TBTF example is The Royal Bank of Scotland was the largest company in the world in 2009. The bank engaged in a deal with ABN Amro, a fatal mistake the led to so many problems. In October 2008, the Royal Bank of Scotland received emergency funding from the government, which amounted to 20billion pounds (Moosa, 2010). However, in February 2009, the bank announced that it had lost 24 billion pounds and required more funding. The government came in and paid 25.5 billion pounds to the bank. This means that bank-owned around 95% of the banks total shares. These examples explain how the government comes in to fund the affected banking institutions to prevent their closure.

In their book ‘Too Big To Fail: The Hazards of Bank Bailouts’, Stern and Feldman explain the reasons for TBTF and how it can be avoided. The book explains that most financial institutions lack market discipline, hence the need for reforms. Such reforms include embracing technology, which might increase bank transparency (Stern & Feldman, 2004). This includes the use of advanced computing and financial tools. Also, banking institutions should increase the direct discipline in regards to pricing and quantity decisions. Again, banks should come up with ways of estimating fair valuations using the complex financial formula. This will help make the banks open to manipulation and easy to carry out cross-bank comparisons.

Research Methodology

Purpose of the Study

The purpose of this study is to find out how the ‘Too Big to Fail’ concept has developed over the years and how the concept affects the economy

The scope

The study will cover the history of the ‘Too Big to Fail’ concept, the causes of these concepts, the consequences, the implications that the concept has on the economy, the alternatives to the concept, and the concept’s future. The research sample will include three to five banks that have faced the ‘Too Big to Fail’ concept. The geographical location will consist of banks that are based in the United States of America. The study will take two to three weeks to be completed.

The source of Data

I will get information from books, journal articles, banking websites and another government website that might have information about the ‘Too Big to Fail’ concept.

Research Questions

1. What effect does the ‘too big to fail’ concept has on the economy?
2. Does the concept of ‘too big to fail’ favor some banks?
3. Is there an alternative to the ‘too big to fail’ concept?
4. Should there be a maximum amount to fund the ‘too big to fail’ institutions?

Techniques and methods adopted

I will use qualitative and quantitative research techniques. The qualitative research techniques will include interviews, document analysis and observation. The quantitative research techniques will consist of observation, which is, counting the number of times the concept has occurred, and surveys and questionnaires.

Summary

The study has explained the meaning and origin of the concept of ‘Too Big to Fail’. The TBTF is very important as it has saved several prominent financial institutions from collapsing. However, the prices of determining which bank is big enough to warrant funding do not include the concept of laissez-faire in finance. Also, the concept means that some banks can take advantage of the government funding and misuse their funds since the management knows the government will fund it with the taxpayer’s money. From the research, it is evident that an alternative to TBTF needs to be implemented. For example, the money used to fund the collapsing banks should create employment for many people who are jobless in the country. Also, the funds can be used to form other financial institutions and form better management that will foresee the bank rise to its best. Generally, the study has revealed that the concept has several consequences to the economy; hence proper considerations should be taken before embarking on it.

References

Kaufman, G. G. (2014). Too Big to Fail in Banking: What Does it Mean? Journal of Financial Stability, 13, 214-223. doi:10.1016/j.jfs.2014.02.004

Moosa, I. (2010). The Myth of Too Big to Fail. Springer.

Moosa, I. A. (2010). The Myth of Too Big to Fail. Journal of Banking Regulation, 11(4), 319-333. doi:10.1057/jbr.2010.15

Stern, G. H., & Feldman, R. J. (2004). Too Big to Fail: The Hazards of Bank Bailouts. Brookings Institution Press.

Strahan, P. E. (2013). Too Big to Fail: Causes, Consequences, and Policy Responses. Annual Review of Financial Economics, 5(1), 43-61. doi:10.1146/annurev-financial-110112-121025