Too Big Too Fail Financial Institutions

Governmental Rescues of “TBTF” Financial Institutions (Staff, 2010)

Introduction. TBTF refers to a bank or other financial institution that federal regulators determine is too important to fail in a disorderly manner without protecting at least some creditors who are not otherwise protected by the federal safety net for banks. (Staff, 2010) Three reasons why an institution is considered TBTF are: (1) The institution is very large in size and is a leader in an important sector(s) of the financial market. (2) The institution is a significant counterparty in financial transactions with other important institutions. (3) The institution has a large degree of public visibility and similar risk factors as other important institutions. When one institution fails, the publicity can create “common shock” which causes a loss of confidence in institutions with similar risk exposures. (Staff, 2010)

Federal financial support is provided in two ways to prevent institutions considered as TBTF from failing. An assisted merger may be arranged by federal regulators in which one institution is given financial support to make it possible for that institution to acquire another that is in danger of default. If no private-sector merger partner is available to acquire the failing TBTF institution, federal regulators may provide direct financial assistance to keep the failing institution operational. Use of either method protects a portion of uninsured creditors of a TBTF institution.

Executive Summary. (Staff, 2010)

The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) was used in an attempt to narrow the scope of the TBTF rationale. TBTF continued to affect the banking system despite FDICIA. Both Fannie Mae and Freddie Mac (government-sponsored enterprises) were viewed as TBTF prior to the financial crisis.

Federal regulators have intervened in the capital markets since 1970 but until the recent recession, investors were not sure that the federal...