The federal financial safety net is intended to protect large financial institutions and their creditors from failure and to reduce the possibility of "systemic risk" to the financial system. However, federal guarantees can encourage imprudent risk taking, which ultimately may lead to instability in the very system that the safety net is designed to protect.
• A contributing factor to the financial crisis of 2007 and 2008 was the government's long history of protecting creditors from losses.
• When investors are protected by the government, they feel little need to demand higher yields as compensation for risk. Creditors also feel less urgency to monitor firms that are implicitly protected, weakening market discipline.
• Both effects encourage risk-taking, which makes firms more likely to experience distress and require bailouts to remain solvent. This self-reinforcing cycle is the essence of the too-big-to-fail (TBTF) problem.
• The nature of TBTF suggests that the safety net will grow ever larger over time. According to Richmond Fed estimates, the safety net covered up to $25 trillion in liabilities at the end of 2011, or 61 percent of the entire financial sector.
• To reduce the TBTF problem and improve financial stability, large firms must be allowed to fail without government assistance and creditors must not be protected from losses.
Occasional turbulence in financial markets is inevitable. There will always be short-term "shocks" that spark new awareness of previously unknown risks, just as the housing market decline that started in 2006 made clear that some financial institutions had taken on greater risk than many investors had realized.
Shocks, however, do not easily or frequently lead to large-scale panics like the global financial crisis of 2007 and 2008. Many complicated factors led to that outcome. Among the most important factors was a long history of government interventions that led market participants to expect government rescues in the event of distress. That financial "safety net" may make market participants less inclined to protect themselves from risk, making financial instability and bailouts a more common and severe occurrence.
What is "Too Big To Fail?"
Part of the government's financial safety net is explicit, such as deposit insurance that protects relatively small investors such as households and small businesses. Commercial banks are charged fees for that service and are supervised, which limits their incentive to take risk.
A large portion of the safety net is ambiguous and implicit, however, meaning that it is not spelled out in advance. For decades the federal government has proven its willingness to intervene with emergency loans when institutions seen as "too big to fail" (TBTF) are on the brink of collapse. Typically, it is not the TBTF firm itself that policymakers seek to protect, but rather its creditors and the markets that the firm relies on for funding. Ultimately, policymakers hope to protect real economic activity. Market participants conduct their business making educated guesses about which markets may be supported in times of distress.
Implicit guarantees effectively subsidize risk. Investors in implicitly protected markets feel little need to demand higher yields to compensate for the risk of loss. Implicitly protected funding sources are therefore cheaper, causing market participants to rely more heavily on them. At the same time, risk is more likely to accumulate in protected areas since market participants are less likely to prepare for the possibility of distress — for example, by holding adequate capital to cushion against losses, or by building safeguarding features into contracts — and creditors are less likely to monitor their activities. This is the so-called "moral hazard" problem of the financial safety net: The expectation of government support weakens the private sector's ability and willingness to limit risk, resulting in excessive risk taking.
The more widespread the TBTF problem, the more likely the financial system is to require periodic bailouts to remain solvent, resulting in an even bigger government safety net. This self-reinforcing cycle is the essence of the TBTF problem.
Although the term "too big to fail" has become the popular way to talk about financial safety net issues, it is a misnomer. Protection of some creditors can happen even if a firm fails — that is, even if the shareholders lose everything and management is replaced. In addition, creditors can be protected when government lending causes a firm’s bankruptcy to be delayed, since that allows certain creditors to exit without losses before bankruptcy is declared. The Fed's discount window has done this in the past (Schwartz 1992).
It is difficult to precisely measure the TBTF problem since the nature of the problem does not lend itself easily to study, as argued by Gary Stern, former president of the Federal Reserve Bank of Minneapolis, and Ron Feldman, the Minneapolis Fed's current head of Supervision, Regulation, and Credit, in their book on the subject (Stern and Feldman 2004). There is no direct way to observe private markets' assessment of firms or activities that are implicitly protected. Moreover, the amount of the subsidy provided by implicit support exists only on the margin and is likely to vary across firms and activities. These characteristics make it difficult to directly identify the effects of TBTF treatment on, for example, the relative performance of large and small banks (Ennis and Malek 2005).
A growing literature has tried to measure the funding advantages of implicitly protected firms. Perhaps the most salient evidence of TBTF lies with Fannie Mae and Freddie Mac, the two firms that were most broadly viewed as implicitly supported by a government backstop. For decades markets have been willing to lend more cheaply to these institutions than to competitors that do not benefit from government support, arguably leading to greater risk-taking in mortgage markets (Our Perspective: Housing Finance Policy). Economist Wayne Passmore at the Federal Reserve Board of Governors has estimated the value of that subsidy between $122 billion and $182 billion (Passmore 2005). Suspicions of government support were proven correct when the firms were taken into government conservatorship during the financial crisis.
The Richmond Fed's view is that the moral hazard from the TBTF problem is pervasive in our financial system. The history of government interventions — from the bailout of Continental Illinois National Bank and Trust Company in 1984 to the public concerns raised during the Long Term Capital Management crisis in 1998 — shaped market participants' expectations of official support leading up to the events of 2007-08 (Haltom and Lacker 2014). According to Richmond Fed estimates, the proportion of total U.S. financial firms' liabilities covered by the federal financial safety net has increased by 27 percent during the past 12 years. The safety net covered up to $25 trillion in liabilities at the end of 2011, or 61 percent of the entire financial sector. Nearly two-thirds of that support is implicit and ambiguous (Marshall, Pellerin, and Walter 2013).
Why Does This Problem Exist?
It is easy to see why the TBTF problem developed. The potential damage from a large firm's failure is so great that governments feel compelled to intervene. That damage comes from at least three forms of spillovers, but the long-term effects of government bailouts weakens the case for intervention.
Most directly, when a firm fails, it may be unable to honor its financial obligations to other firms, which can snowball until other firms are jeopardized despite being fundamentally sound (Athreya 2009). To some extent, firms will protect themselves from this possibility by charging a premium to counterparties whose risks are unclear. However, the expectation of safety net protection reduces the likelihood that a firm will face the full cost of that risk, so it will be less likely to charge those higher premiums.
A large failure also can provide information about real risks in the economy. However, it is not obvious that it would be desirable or even possible to stop that kind of information from spreading.
Finally, a large firm's failure can cause market participants to scramble to reassess which of their counterparties are likely to receive government support. This type of panic contributed to the most tumultuous days of the financial crisis after the failure of investment bank Lehman Brothers in September 2008. Earlier that year, the investment bank Bear Stearns was rescued when the Federal Reserve lent funds to JPMorgan Chase to purchase the ailing bank, the first time the Fed had directly extended financing to an investment bank. This unprecedented action, along with others taken to treat the financial market strains, likely signaled that similar support would be available for other firms. Yet in September, Lehman Brothers, at nearly twice the size of Bear Stearns, was allowed to fail. The government appeared to be offering support on a case-by-case basis in a time of already extraordinary market uncertainty (Steelman and Weinberg 2008). But by that time, many investors were too entrenched in their contracts to charge premiums for the risks to which they now understood they were exposed — in particular, the risk that the government would not prevent failures. Lehman's failure was a turning point after which the financial crisis escalated severely, leading to extraordinary volatility and worsening the downturn in global economic activity. This type of panic — resulting from reassessment of the likelihood of protection — would cease to exist if the government's safety net boundaries were made explicit and transparent in advance.
In other words, the negative, long-term effects of a large firm's failure can be amplified by government support. In the short term, the spillovers create pain. In the extreme, they could translate to reduced economic activity, increased unemployment, and restricted credit to households and businesses. They make the case for intervention appear stronger, even as policymakers understand the moral hazard problems that intervention creates for the future, contributing to the likelihood of future crises (Lacker 2011).
For this reason, ambiguity around the implicit safety net nearly guarantees that it will grow ever larger over time (Lacker and Weinberg 2010), as the Richmond Fed's estimates have displayed (How Large Is the Federal Financial Safety Net?).
How Can the TBTF Problem Be Fixed?
In the wake of the financial crisis, most policymakers agree that TBTF is a problem that must be addressed to reduce the frequency and magnitude of financial crises. However, financial reforms that have been adopted since the crisis have not solved TBTF.
Recent efforts have focused on broadening the scope of regulation to include all institutions and markets that could be a source of shocks that lead to financial crises. This is often referred to as systemic risk regulation. The 2010 Dodd-Frank regulatory reform law took large steps in this direction, mandating regulators to consider the health of the financial system as a whole when they supervise individual firms, creating the Financial Stability Oversight Council to monitor risks to financial stability, and appointing the Fed as the regulator of financial firms that have been designated by FSOC as "systemically important."
Regulation alone cannot overcome the moral hazard that results from the government safety net, however. Regulations impose burdens of their own, creating incentive to innovate around them and forcing regulators and rule makers to adapt to an ever-changing financial landscape (Lacker 2011). It will always be a challenge for regulators to be as intimately familiar with the complex financial arrangements into which a given firm has entered as that firm is itself. Policymakers have historically tended to follow financial crises with reforms to attempt to constrain risk-taking, and in the next crisis risk shows up in new forms.
Instead, it is essential for firms to face incentives, separate from the requirements of regulators, to limit their own risk taking. This is called market discipline, and it is a critical element of a well-functioning and stable financial system (Hetzel 2009). Market discipline is created when creditors expect to face the full costs of a firm's losses, and so they have a greater interest in monitoring the risk of firms with which they do business. By definition, implicit guarantees erode market discipline.
Therefore, there is no substitute for limiting the government's safety net. A useful first step would be for policymakers to publicly commit to adhering to a safety net policy that is transparent and limited in scope. There is a range of reasonable views on the exact contours of the safety net's boundaries. In the Richmond Fed's view, the safety net should focus on smaller creditors because a larger safety net has proven to grow inexorably over time. Regardless of where the safety net boundaries ultimately are drawn, making those boundaries explicit should be at the forefront of policymakers' efforts to address the TBTF problem.
The actions of the federal government, including the Federal Reserve, since the 2007-2008 financial crisis have no doubt made it harder for commitments against intervention to be credible. The Fed has some experience dealing with seemingly insurmountable credibility problems, however. Many onlookers thought it would be impossible for the Fed to establish credibility that it would fight inflation in the late 1970s. The solution then was to build a reputation for being willing to tighten monetary policy to dampen inflation even if it meant higher unemployment in the short run (Our Perspective: Price Stability and Monetary Policy). Similarly, only building a reputation to limit lending powers — perhaps by letting large firms fail — can avoid the moral hazard the central bank's lending authority has the potential to create (Goodfriend and Lacker 1999). The stance of the Richmond Fed is that, like in the 1970s, the long run benefits of credibility are likely to outweigh the short-term costs of the measures taken to establish it.
One step that could help establish credibility against intervention without enduring an institution's costly failure is the creation of "living wills." Living wills are blueprints, written by firms and evaluated in advanced by regulators, for winding down large financial institutions in the event of financial distress. The purpose of living wills is to provide a plan for how a firm’s operations could be unwound under the bankruptcy code in a manner that minimizes spillovers and is unassisted from government protection of creditors, preferably with lower costs than a process featuring government assistance. Therefore, living wills present policymakers with a viable alternative to emergency "bailouts" in a crisis. The more credibly living wills are written, the more likely regulators would be to allow a large firm to fail, and the more likely that firms and creditors would be to operate without the expectation of government assistance (Lacker and Stern 2012). Living wills have the potential to truly end the TBTF problem by making the government safety net the less attractive option in a crisis.
Additionally, certain reforms could make the bankruptcy process less costly and disruptive when it comes to large firms. Currently, certain short-term financial instruments and derivatives are exempt from bankruptcy's "automatic stay," a safe harbor treatment that may over-encourage the use of such instruments, thereby enhancing the fragility of the financial system. Policymakers should examine the bankruptcy code for opportunities, such as limiting this exemption, that could reduce the spillovers that result from failing firms when they do not receive government support. This could make bankruptcy — rather than bailouts — the more attractive option for regulators during a crisis (Lacker 2014).
Taking Away the Ability to Conduct Bailouts
To help reduce the possibility that a large firm would have to fail for the government's commitment against bailouts to be demonstrated, an additional option is for policymakers to be "tied to the mast" with explicit rules that limit their ability to intervene.
The Dodd-Frank Act attempted this by scaling back the Fed’s ability to lend in "unusual and exigent" circumstances under section 13(3) of the Federal Reserve Act. Rather than lending to specific firms as it did during the financial crisis, the Fed can now offer support only to entire markets, and only with advance approval from the U.S. Treasury. The Fed still possesses expansive authority to lend in a way that protects creditors, however, since even a broad-based lending program could be particularly attractive to certain troubled firms. The Fed’s 13(3) authority is inessential to the Fed’s core function of providing monetary stability, and the expectation of bailouts that it perpetuates, given the Fed's actions in its history, continues to threaten financial stability (Haltom and Lacker 2014).
Other aspects of the Dodd-Frank Act have the potential to broaden policymakers' discretion if not implemented carefully. For example, regulating systemic risk requires some specificity about what makes an institution systemically important. That alone is a difficult question. Despite the notion that some firms are too big to fail, size is not the only determinant of riskiness. A firm's connectedness to others in the financial system is also important. Connectedness, however, is often hard to determine; there are many possible direct and indirect avenues through which one firm may be exposed to others, and those exposures evolve continuously with innovation (Price and Walter 2011). Therefore, the basic task of identifying systemically important firms necessarily entails discretion (Grochulski and Slivinski 2009).
Another major provision of the Dodd-Frank Act known as Orderly Liquidation Authority (OLA) gives the government authority to step in to unwind the liabilities of failing large financial institutions and allocate losses among creditors. It is difficult to specify in advance the terms of such arrangements since designating any threshold for which creditors will bear losses creates considerable incentive for investors to place themselves on the beneficial side of the line, subsidizing activities located there. Thus, OLA gives the Federal Deposit Insurance Corporation broad discretion over how it balances the competing goals of buffeting financial market distress (perhaps bailing out short-term creditors) and limiting moral hazard (perhaps allowing creditors to bear losses) (Pellerin and Walter 2012). To the extent that such discretion in policymaking is unavoidable, it should include clear terms of accountability like the least-cost resolution requirements that apply to the Federal Deposit Insurance Corporation when it unwinds failing banks (Lacker and Weinberg 2010). Once credible living wills are in place, however, repealing OLA would help end the expectation of bailouts.
Many onlookers believe financial crises and excessive risk-taking are inherent features of a market system. The view of the Richmond Fed is that poor incentives, often provided by well-intended but unwise market interventions, are more likely to be behind episodes of financial panic (Lacker 2013). The financial crisis of 2007-08 was the culmination of many factors, but chief among them was the long history of government intervention that extends back at least to the late 1970s. Such interventions created incentives for increased risk-taking. These incentives are much harder to correct than they were to create, but doing so is imperative to financial stability.
Richmond Fed Research
Athreya, Kartik B. "Systemic Risk and the Pursuit of Efficiency." Federal Reserve Bank of Richmond 2009 Annual Report.
Ennis, Huberto, and H.S. Malek. "Bank Risk of Failure and the Too-Big-to-Fail Policy." Federal Reserve Bank of Richmond Economic Quarterly, Spring 2005, vol. 91, no. 2, pp. 21-44.
Goodfriend, Marvin, and Jeffrey M. Lacker. "Limited Commitment and Central Bank Lending." Federal Reserve Bank of Richmond Economic Quarterly, Fall 1999, vol. 85, no. 4, pp. 1-27.
Grochulski, Borys, and Stephen Slivinski. "System Risk Regulation and the 'Too Big to Fail Problem.'" Federal Reserve Bank of Richmond Economic Brief 09-07, July 2009.
Haltom, Renee, and Jeffrey M. Lacker. "Should the Fed Have a Financial Stability Mandate? Lessons from the Fed’s First 100 Years." Federal Reserve Bank of Richmond 2013 Annual Report.
Hetzel, Robert L. "Should Increased Regulation of Bank Risk-Taking Come from Regulators or from the Market?" Federal Reserve Bank of Richmond Economic Quarterly, Spring 2009, vol. 95, no. 2, pp. 161-200.
Lacker, Jeffrey M. "The Path to Financial Stability." Speech to the Stanford Institute for Economic Policy Research at Stanford University, Stanford, Calif., February 11, 2014.
Lacker, Jeffrey M. "Financial System Fragility — Inherent or Induced?" Federal Reserve Bank of Richmond Econ Focus, Second Quarter 2013, p. 1.
Lacker, Jeffrey M. "Understanding the Interventionist Impulse of the Modern Central Bank." Speech to the CATO Institute 29th Annual Monetary Conference, Washington, D.C., November 16, 2011.
Lacker, Jeffrey M. "Innovation in the New Financial Regulatory Environment." Speech to the 2011 Ferrum College Forum on Critical Thought, Innovation & Leadership, Roanoke, Va., April 7, 2011.
Lacker, Jeffrey M., and John A. Weinberg. "Now How Large is the Safety Net?" Federal Reserve Bank of Richmond Economic Brief 10-06, June 2010.
Marshall, Liz, Sabrina R. Pellerin, and John R. Walter. "How Large Is the Federal Financial Safety Net? New Estimates." Federal Reserve Bank of Richmond Special Report, February 2013.
Pellerin, Sabrina R., and John R. Walter. "Orderly Liquidation Authority as an Alternative to Bankruptcy." Federal Reserve Bank of Richmond Economic Quarterly, First Quarter 2012, vol. 98, no. 1, pp. 1-31.
Price, David A., and John R. Walter. "Identifying Systemically Important Financial Institutions." Federal Reserve Bank of Richmond Economic Brief 11-04, April 2011.
Steelman, Aaron, and John A. Weinberg. "The Financial Crisis: Toward an Explanation and Policy Response." Federal Reserve Bank of Richmond 2008 Annual Report.
Lacker, Jeffrey M., and Gary H. Stern. "Lacker and Stern: 'Large Banks Need Living Wills.'" Wall Street Journal, June 12, 2012, p. A13.
Passmore, S. Wayne. "The GSE Implicit Subsidy and the Value of Government Ambiguity." Federal Reserve Board of Governors Finance and Economics Discussion Series 2005-05, February 2005.
Schwartz, Anna. "Misuse of the Discount Window." Federal Reserve Bank of St. Louis Review, September/October 1992, vol. 75, no. 5, pp. 58-69.
Stern, Gary H., and Ron J. Feldman. Too Big to Fail: The Hazards of Bank Bailouts. Washington, D.C.: Brookings Institution Press, 2004. (Excerpts from the book are available on the Minneapolis Fed's website.)
Too Big to Fail
A full list of related research and speeches from the Richmond Fed