What Are Companies That Are Too Big to Fail?

The concept of “too big to fail” (TBTF) refers to certain companies, particularly financial institutions, whose collapse would have catastrophic consequences for the broader economy. This idea gained prominence during significant financial disruptions, highlighting the interconnectedness of large entities within the financial system. The significance of TBTF stems from the potential for a single firm’s failure to trigger a cascade of instability, impacting countless individuals and businesses.

Understanding “Too Big to Fail”

The term “too big to fail” describes a business or sector so deeply embedded in a financial system that its failure would be disastrous. Governments often consider intervening with rescue measures to prevent such an economic catastrophe. The term gained prominence following a 1984 Congressional hearing, as policymakers began to acknowledge the systemic risks associated with large financial institutions.

“Too big to fail” is rooted in the concept of systemic risk. Systemic risk refers to the potential for a shock to one institution to cause significant disruption throughout the entire financial system and the broader economy. The failure of a large, interconnected institution can create a domino effect, leading to widespread instability.

Governments provide support to TBTF firms because the consequences of a disorderly failure for the broader economy are seen as far outweighing the costs of intervention. If creditors believe an institution will not be allowed to fail, they may not demand as much compensation for risks, potentially weakening market discipline. This can lead to such firms taking on more risk, anticipating assistance if their ventures go awry.

Key Characteristics of Systemically Important Companies

Companies classified as “too big to fail,” or Systemically Important Financial Institutions (SIFIs), possess several distinct characteristics. The Financial Stability Oversight Council (FSOC) in the United States monitors and designates such institutions.

Immense Size

One characteristic is their immense size, often measured by total assets or market capitalization. Systemically important banks, for instance, can have billions or even trillions of dollars in assets. The larger the institution, the greater the potential fallout if it were to fail. This size-based assessment relates to the volume of financial services provided and the estimated negative impact on the system if those services became unavailable.

Interconnectedness

Another factor is a high degree of interconnectedness within the financial system. This can manifest through complex derivatives, interbank lending, or direct and indirect financial contracts with other institutions. The intricate web of relationships means that distress in one part of the institution or its counterparties can rapidly spread throughout the system.

Global Reach and Complexity

Global operational reach and complexity also contribute to systemic importance. Many SIFIs are multinational corporations with activities spanning multiple jurisdictions.

Lack of Substitutability

Finally, the lack of substitutability for their services is a defining attribute. These institutions often play a unique role in providing essential financial market infrastructure or services, such as treasury services for other financial institutions. If such a dominant player were to fail, there would be no readily available alternative to fill the void, leading to significant disruption.

Government Actions During Financial Distress

When a systemically important company faces severe financial distress, governments and central banks often undertake actions to prevent broader economic collapse and protect the national economy. This intervention is commonly referred to as a “bailout,” a financial rescue package provided to an entity on the brink of bankruptcy.

Bailouts can take various forms:
Direct capital injections into distressed institutions, where the government purchases shares or provides direct funds.
Provision of liquidity support, such as emergency loans from the central bank, to ensure the institution can meet its short-term obligations.
Liability guarantees for deposits or other debts, reassuring creditors and preventing a run on the institution.
Asset purchases, where the government acquires impaired or “toxic” assets from the struggling entity, cleaning up its balance sheet. For example, the Troubled Asset Relief Program (TARP) authorized the U.S. Treasury to use funds to stabilize financial markets.

During the 2008 financial crisis, the failure of major firms led to a broader economic downturn, prompting government bailouts to stabilize the system. Policymakers aim to protect depositors, maintain market stability, and ensure the continued functioning of financial services. While bailouts can be controversial due to their use of taxpayer funds, they are implemented to avoid potentially catastrophic ripple effects across the economy.

Global Regulatory Frameworks

In the aftermath of the 2008 global financial crisis, significant regulatory reforms were implemented worldwide to address the “too big to fail” problem. These frameworks aim to reduce the likelihood of large institutions failing and facilitate their orderly resolution if distress occurs. The G20 committed to fundamental reforms of the global financial system to build more resilient financial institutions.

Increased Capital Requirements

One key initiative is the increase in capital requirements for banks, notably through the Basel III accord. Banks are now required to maintain a minimum Common Equity Tier 1 (CET1) ratio of 4.5% of their risk-weighted assets, with an additional capital conservation buffer of 2.5%, bringing the total common equity requirement to 7%. Global Systemically Important Banks (G-SIBs) are subject to even higher capital levels through capital surcharges.

Liquidity Requirements

Liquidity requirements were also introduced to ensure banks have sufficient liquid assets to withstand periods of stress. Basel III established a minimum leverage ratio, requiring banks to maintain Tier 1 capital in excess of 3% of their total consolidated assets. For large banks and SIFIs, this leverage ratio can be as high as 5% or 6%.

Stress Testing

Stress testing has become a standard regulatory tool. The Federal Reserve, for example, conducts annual stress tests to assess whether banks are sufficiently capitalized to absorb losses during stressful economic conditions. Banks are required to conduct and publicly disclose their own stress test results.

Resolution Authorities and “Living Wills”

Frameworks for resolution authorities and “living wills” were developed. The Dodd-Frank Act requires large banking organizations and other designated firms to submit resolution plans, or “living wills,” to regulators. These plans detail how a firm could be rapidly and orderly resolved under bankruptcy or other insolvency regimes in the event of material financial distress, without causing systemic disruption or relying on taxpayer bailouts.