How Global Finance Works
Too Big to Fail
Why some banks are so large and connected that governments feel they must rescue them, the moral hazard this creates, and reforms since 2008 including the Credit Suisse case.
Some banks are so large and interconnected that their failure could bring down the financial system. Governments feel compelled to rescue them. This is the too big to fail problem.
Why governments rescue big banks
- Contagion: other banks and firms are owed money by the failing bank.
- Payments: big banks run essential payment and clearing systems.
- Confidence: a big failure can trigger panic and runs elsewhere.
The 2008 experience
When Lehman Brothers was allowed to fail in September 2008, panic spread worldwide. Governments then rescued many other large institutions, such as AIG, and injected capital into banks.
Moral hazard
If banks expect to be rescued, they may take more risks, knowing taxpayers will absorb losses. Creditors may lend to them cheaply, giving big banks an unfair advantage.
Reforms since 2008
- Systemically important banks: the Financial Stability Board designates global systemically important banks, or G-SIBs, which must hold extra capital.
- Total loss-absorbing capacity: big banks must have debt that can be converted to equity or written off in a failure.
- Resolution planning: “living wills” describing how a bank could be wound down without taxpayer money.
- Stress tests to check if banks can survive severe scenarios.
India’s RBI designates domestic systemically important banks, such as SBI, HDFC Bank and ICICI Bank, which must hold extra capital.
The Credit Suisse test
In March 2023, Credit Suisse, a global systemically important bank, faced a crisis of confidence. Rather than use new resolution tools, Swiss authorities arranged an emergency takeover by UBS, supported by government guarantees and central bank liquidity. Some bondholders’ debt was written off. Critics said the episode showed too big to fail was not solved, and it created an even larger bank.
The debate
Some argue big banks should be broken up; others say stronger capital and resolution rules are enough.
A giant bank is counterparty to thousands of derivatives contracts and holds deposits from many companies. If it fails suddenly, hundreds of firms face losses and payment disruptions. Fearing chaos, the government steps in - exactly what reforms aim to avoid in future.
Capital and resolution rules have improved safety, but the Credit Suisse case showed governments still intervene.
- Very large, connected banks may be rescued to prevent system-wide collapse.
- Expected rescues create moral hazard.
- Reforms include extra capital for G-SIBs, loss-absorbing debt, living wills and stress tests.
- The 2023 Credit Suisse takeover by UBS showed the problem persists.
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