Too Big to Fail

The term too big to fail refers to a corporation, an organization, or an industry sector that is considered by the United States government to be too important to the overall health of the economy to be allowed to fail. Beginning in the 1980s, the term was applied to the banking industry during the Continental Illinois Bank and Trust Company crisis. When Continental Illinois approached insolvency because of bad speculative investments, the Federal Reserve guaranteed Continental's liquidity needs. Eventually, the federal government spent $4.5 million to bail out Continental. When quizzed by the Senate Banking Committee why the Federal Reserve and the Federal Deposit Insurance Corporation did what they did, the regulators responded that they were concerned about the size of the bank (the seventh largest nationally), the number of smaller banks with significant portions of their capital invested in Continental Illinois, the specter of depositor panic and bank distress, and the potential disruption of national payment and settlement systems.

[Page 1583]More recently, the government engaged in its biggest financial bailout in history. Bad mortgage investments essentially froze the credit market by September 2008. The first move by the government was to force Bear Stearns to be taken over by Morgan Stanley. Not wanting to engage in renewing the precedent of government bailouts, the government let Lehman Brothers enter bankruptcy. The demise of Lehman Brothers shook the investment markets, and the domestic and global stock markets plunged. The government then reversed itself and invested an initial $50 billion in AIG, eventually raising that investment to over $100 billion. Finally, the U.S. government approved over $700 billion to rescue the financial markets, taking equity positions in a number of banks in doing so. The rationale for the expenditure of nearly $850 billion was that the banking system was “too big to fail.”

Ironically, while our largest banks may be deemed too big to fail, the smaller so-called community banks may be too small to fail. The FDIC reports the failure rate among banks with assets of $1 billion or more is seven times greater than among banks with less than $1 billion in assets. These community banks are outperforming large banks on most key measures, such as return on assets, charge-offs for bad loans, and net profit margin.

This is remarkable when one considers that just three institutions—Citigroup, Bank of America, and JPMorgan—hold more than 30 percent of the nation's deposits and 40 percent of bank loans to corporations. Unfortunately, while there were 14,000 such community banks in 1985, today there are less than 8,000. In addition, a number of large banks who received the government bailout have announced that they may be using the money to acquire these more successful community banks.

Other Industries

The intervention by the government to rescue the financial community has raised the question of whether other industries are “too big to fail.” For example, until recently, the three companies that controlled the U.S. auto industry, despite competition from foreign automakers, still controlled significant global market share. In addition, the U.S. auto industry invested in manufacturing technologies that lowered the cost of production domestically, and steadily out-sourced production to control labor costs. Relatively cheap fuel prices in the United States also helped the auto industry.

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