Too Big to Fail v. Too Small to Survive

By: Daniel Scheeringa

The Congressional Oversight Panel for the Troubled Asset Relief Program (TARP) has issued its final report, and the TARP program is projected to cost much less than forecast.  Unfortunately, TARP didn’t solve the original problem of “too big to fail”.  The problem is worse today, and the legislative solution may make things even worse.   

Moral hazard is when rational actors take bigger risks than they otherwise would, in the knowledge that someone else will bear the risk.  Although there were previous examples of the moral hazard of bailouts[1], the greatest illustration of this concept came in 2008.  As the financial crisis broke, 18 large investment banks received $208 billion in TARP money to save them from insolvency after they made risky bets on CDO’s.  As the report states, in the case of AIG, the guarantee was extended not only to AIG itself but to its counterparties in its derivatives trades, leaving the government guaranteeing not only banks, but an entire market. (pg. 184)  In one day, the risk was removed from the derivatives market, leaving only profits.  In early 2009, once the immediate danger had passed, the US Treasury ordered stress tests of the 19 biggest banks, and announced it would provide more taxpayer funds to shore up any weakness. Since the crisis began, these banks have only become bigger and more interconnected.  In 1995, six of the largest banks[2] controlled assets equivalent to 17% of GDP, in January 2011, their assets controlled over 45%.[3]

The Dodd-Frank Financial Reform Act sought to address the too big to fail problem.  Title II empowers regulators to seize and dismantle large financial firms that are on the edge of insolvency.  As Fitzpatrick and Thomson describe, orderly liquidation involves multiple steps.  First, a firm must qualify as a covered financial firm, that is, a firm that derives more than 85% of revenue from finance, and any other firm designated as systematically important.  Once a firm is deemed subject to Title II authority, the FDIC assumes receivership and oversees liquidation, preempting the bankruptcy court[4].  Under Title II, the FDIC would have the power to fire management, wipe out the shareholders’ equity, seize assets, sell the assets and close the business.  The FDIC is authorized to borrow unlimited amounts from the US Treasury to keep the firm solvent by extending credit, purchasing assets, or assuming or guaranteeing obligations.[5]  These funds are supposed to be repaid within 60 days, funded by asset sales.  What happens if asset sales don’t raise enough is unknown.

But, as Gordon and Muller explain, the resolution authority may actually make another crisis more likely.  The fact that the funding comes from the taxpayers may stoke public anger about bailouts, which would make regulators hesitant to step in until absolutely necessary.  By the time sick firms go into receivership, they will be in a worse position, and the risk of systemic contagion will be increased.  Intermediate means of intervention, such as lifelines from the Fed, or FDIC interventions short of receivership, are precluded by Dodd-Frank[6].

Too Small to Survive

            While the last few years have been kind to big banks, they have been hard on their small competitors.  Small banks were especially burdened by the moribund real estate market and later by small business defaults.  206 small banks, or 2.4% of all banks operating in the US, failed between January 2007 and March 2010[7].  At a time when the biggest banks are only getting bigger, small banks, whose fortunes are tied to their communities’ economies, are struggling.

            Small bankers are concerned that the new regulatory scheme will only make things worse.  Small bankers complain that the thousands of pages of proposed regulations will increase their compliance costs, forcing them to add to their compliance staff just to keep up with the paperwork.  Historically, compliance costs as a share of operating expenses is two and a half times greater for small banks than large ones.  Money banks spend on compliance is money that can’t be loaned out to small businesses.

Another key concern is Dodd-Frank’s lowering of “swipe fees” for debit card transactions.  Although small banks have a carve-out in the law from the fee limits, they may have to lower their fees anyway, just to remain competitive.  Banking analysts estimate banks will need an additional $1 to $2 billion in assets to sustain the additional costs, which may be difficult for small banks[8].  Bankers report that regulators are telling them that banks with less than $500 million in assets should consider merging.[9]  At a time when Washington claims to be addressing the too big to fail problem, in reality, they seem to be making it worse.


[1] Continental Illinois Bank in 1984, and the hedge fund Long-Term Capital Management in 1998.  For a comprehensive account of the LTCM story, see Roger Lowenstein when genius failed (2000).

[2] JP Morgan Chase, Bank of America, Citigroup, Goldman Sachs, and Morgan Stanley

[3] Testimony of Josh Rosner to the House Oversight Committee, reprinted on (Accessed April 16, 2011) (

[4] PL 111-203 § 202(c)(2)

[5] Id at § 204(d)

[6] Id at § 1101(a)(6)

[7] Craig P Aubuchon and David C. Wheelock the geographic distribution and characteristics of u.s. bank failures, 2007-2010: do bank failures still reflect local economic conditions?  Federal Reserve Bank of St. Louis Review September/October 2010

[8] Testimony of Albert  C Kelly Jr. to the Subcommittee on Financial Institutions and Consumer Credit of the House Committee on Financial Services March 2, 2011.

[9] Testimony of H. Charles Maddy III to the House Committee on Financial Services January 26, 2011.