By Jonas Cabochan and Paolo Magnata

Even before the Global Financial crisis, ‘Too Big to Fail’ institutions were already prevalent in many industrialized economies.

The importance of these institutions is great enough for countries such as the United States (US) and the United Kingdom (UK) to give them their fair share of bailouts over the past centuries. In 2001, for one, the US government was forced to ground all air traffic for several days after the 9/11 terrorist attack. Thus, they had to compensate for a financial loss of almost $5 billion in the air carrier industry. In the UK during the late 1700s, the government gave financial assistance to the East India Company, a decision that played a big factor in the Boston Tea Party.

These are only some of the many instances where governments had to save ‘Too Big to Fail’ institutions from failing. The government continues to bail out these companies and institutions simply because of their necessity in keeping the macroeconomic elements of the country in place. Adam Smith’s Wealth of Nations points out the necessity for special government assistance for companies that are immensely large and too systematically risky to fail. If these institutions were to default, the surges in the economy would be disastrous, especially if these companies are financial institutions.

Ingrained in the economy

When companies reach the stage in which their average cost to produce is lower than ever because of their size and productivity, it has several repercussions for the overall welfare of the economy and its producers and consumers. For one, they cannot fail because of their size and reach. Coupled with reduced costs of production, these companies would have stable sales; so, even if they somehow stop growing, the cost of maintaining everything should not bother them. Also, at this stage it can be assumed that the names of companies that are ‘Too Big to Fail’ are already household names. Thus, a bias is created that works for them. Instead of making them more competitive, they become complacent. This would make the growth of new companies a challenge, and if competition is non-existent or weak for such companies, consumers would most likely pick the well-known companies for buying the particular goods and/or services they need. It is with their size and very nature that some companies just cannot fail.

Furthermore, they shouldn’t fail because to be that sizeable and have that reach, they would have to be a company that is incredibly ingrained in the economy; it’s quite possible that other companies have become reliant upon the goods or services of a company that is too big to fail such that their removal from the economic system would entail no less than a catastrophic breakdown of a country’s economy. However, if their reach is in the international level, then there is the possibility of a global economic crisis should they shut down. Thus, governments and banks have to intervene and pay bailouts for these companies if they are in danger of shutting down or closing, otherwise there would be a domino effect of other companies and consumers being affected. For them, the opportunity cost of not paying the bailout is greater than that of paying it, making it the obvious choice of action.

But it must be pointed out; however, that size is not the only factor that makes these companies too big to fail. Drexel and BCCI, despite their size, were allowed to fail because their failure created little risk of contagion as they were somewhat disconnected from the system. When discussing ‘Too Big to Fail’ companies and institutions, one does not look only at the size, but also at how interconnected they are. In other words, one must look at the systemic risk coupled with the existence of these institutions and take into consideration the potential spillover effects leading to widespread depositor runs, impairment of public confidence in the broader financial system, or serious disruptions in domestic and international payment and settlements systems.

Success at all costs

The existence of such companies and institutions requires the government to create ex ante policies that will hopefully prevent a failure from occurring and ex facto policies that minimize the effects of an actual failure. The problem with such a situation is that it makes these institutions more confident in making high-risk-high-return investments given that if they fail, they still have the government to run off to. Also, accountability is a big problem regarding these cases. Using the 2008 global financial crisis as reference, the individuals responsible for the crisis were barely touched. Politics at its best and individuals in the Central Bank that were also stakeholders in the ‘Too Big To Fail’ institutions became obstacles in creating proper regulations in the system. Inefficiency in the banking system also increases the consequences of the ‘Too Big to Fail’ policies as banking markets’ uncontrollable economic conditions inevitably result to the failure of inefficient banks. The government’s ‘Too Big to Fail’ policies still encapsulate these inefficient institutions, which create a cycle that current policies cannot escape at the moment.

There has been a lot of public opposition regarding the continual bailout of these ‘Too Big to Fail’ institutions and a lot more controversy has arisen because of the lack of transparency. Policy reformation is necessary and a lot less lobbying would do much good in making the system more efficient. If the correct measures are met, the existence of these institutions, as grave as the implications of their failure might impose on the economy, will be tolerable. As of now, the system seems to be intact and these institutions are working under the conditions that have been preset to make their effects more controlled to some extent; however, there are a lot of loopholes that the institutions can use to overcome these preset regulations. In the end, the government must still swoop in and save these companies, even if it’s only temporary solution, because these institutions cannot and simply will not be allowed to fail.

Sources:
http://www.levyinstitute.org/publications/too-big-to-fail
http://www.investopedia.com/terms/t/too-big-to-fail.asp
http://www.newyorkfed.org/research/epr/2014/1403sant.pdf
Gup, Benton E. Too Big to Fail: Policies and Practices in Government Bailouts. Westport, CT: Praeger, 2004. Web.
Jasper, William F. “Bank Bailouts Without End.” New American 20.5 (2014): 18-23. Web.

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