CRS – Systemically Important or “Too Big to Fail” Financial Institutions. Marc Labonte, Specialist in Macroeconomic Policy. September 19, 2014.

“Although “too big to fail” (TBTF) has been a perennial policy issue, it was highlighted by the near-collapse of several large financial firms in 2008. Financial firms are said to be TBTF when policy makers judge that their failure would cause unacceptable disruptions to the overall financial system, and they can be TBTF because of their size or interconnectedness. In addition to fairness issues, economic theory suggests that expectations that a firm will not be allowed to fail create moral hazard—if the creditors and counterparties of a TBTF firm believe that the government will protect them from losses, they have less incentive to monitor the firm’s riskiness because they are shielded from the negative consequences of those risks. If so, they could have a funding advantage compared with other banks, which some call an implicit subsidy. S.Con.Res.8, passed by the Senate on March 22, 2013, and H.Con.Res. 25, as amended and passed by the Senate on October 16, 2013, create a non-binding budget reserve fund that allows for future legislation to address the TBTF funding advantage. There are a number of policy approaches—some complementary, some conflicting—to coping with the TBTF problem, including providing government assistance to prevent TBTF firms from failing or systemic risk from spreading; enforcing “market discipline” to ensure that investors, creditors, and counterparties curb excessive risk-taking at TBTF firms; enhancing regulation to hold TBTF firms to stricter prudential standards than other financial firms; curbing firms’ size and scope, by preventing mergers or compelling firms to divest assets, for example; minimizing spillover effects by limiting counterparty exposure; and instituting a special resolution regime for failing systemically important firms. A comprehensive policy is likely to incorporate more than one approach, as some approaches are aimed at preventing failures and some at containing fallout when a failure occurs. Parts of the Wall Street Reform and Consumer Protection Act (Dodd-Frank Act; P.L. 111-203) address all of these policy approaches. For example, it created an enhanced prudential regulatory regime administered by the Federal Reserve for non-bank financial firms designated as “systemically important” by the Financial Stability Oversight Council (FSOC) and banks with more than $50 billion in assets. About 30 U.S. bank holding companies and a larger number of foreign banks have more than $50 billion in assets, and the FSOC has designated two insurers (AIG and Prudential) and GE Capital as systemically important. According to the insurer MetLife, FSOC has proposed to designate it as well. In addition, eight banks headquartered in the United States will be assessed capital surcharges under Basel III. H.R. 4881, ordered to be reported by the House Financial Services Committee on June 20, 2014, would place a one-year moratorium on FSOC designations. H.R. 5016, which passed the House on July 16, 2014, would not allow any funds to be used to designate a non-bank as systemically important or as posing a systemic threat to financial stability. S. 2270, as passed by the Senate, and H.R. 5461, as passed by the House, would allow regulators to exempt insurers from bank capital requirements (the “Collins Amendment” to the Dodd-Frank Act).”