Too Big to Fail

1. The "Too Big to Fail" Problem: A Costly Credibility Gap

Despite some progress, our central warning is that not enough has been done to reduce creditors’ expectations of TBTF protection.

Defining TBTF. The "Too Big to Fail" (TBTF) problem arises when uninsured creditors of large, systemically important banks expect government protection if their bank fails, shielding them from losses they would otherwise incur. This expectation extends beyond explicit deposit insurance caps, creating an implicit government guarantee. The term "big" refers not just to asset size, but to a bank's critical role in the financial system, where its failure could trigger widespread disruption.

Moral hazard's toll. This perceived safety net leads to "moral hazard," where TBTF banks take on excessive risks because their creditors have less incentive to monitor their activities or demand higher returns for risk. Creditors, confident in a bailout, provide funding at artificially low prices, encouraging banks to pursue riskier loans or investments. This misallocation of resources diverts capital to less productive uses, ultimately wasting societal wealth and hindering economic growth.

Time inconsistency. The core of the TBTF problem is a lack of credibility in policymakers' pledges to avoid bailouts. When faced with a large bank's imminent failure, policymakers often prioritize short-term financial stability over long-term moral hazard costs, leading them to provide protection despite earlier commitments. Creditors, recognizing this "time inconsistency," continue to expect bailouts, perpetuating the cycle of excessive risk-taking.

2. TBTF's Pervasive and Growing Economic Costs

The costs of lost output can dwarf the transfers from financial losses.

Beyond fiscal transfers. While banking crises often involve massive fiscal costs—government bailouts funded by taxpayers—these transfers are not the true economic cost of TBTF. The real burden lies in the wasted investment and lost output caused by the resource misallocation that TBTF guarantees encourage. For instance, the U.S. savings and loan bailout involved $150 billion in fiscal transfers, but the lost output was estimated at $500 billion, highlighting the far greater economic damage.

Evidence of pervasiveness. The existence and scope of TBTF protection are evident through various measures:

• Subsidy estimates: Financial valuation models show significant implicit subsidies for large banks, especially in developing countries.
• Event studies: Stock market reactions to events like the Continental Illinois bailout or the Long-Term Capital Management rescue indicate increased shareholder wealth for TBTF institutions.
• Credit rating agencies: Agencies often assign higher "deposit" or "issuer" ratings than "financial strength" ratings, reflecting an implicit government backstop.
• Banking crisis costs: Policies akin to TBTF, such as unlimited guarantees, have been linked to a tenfold increase in the fiscal cost of banking crises.

Corroding discipline. TBTF policies undermine market discipline, particularly when a bank's financial health is deteriorating. Instead of facing higher funding costs or reduced access to capital, weak TBTF banks can continue to attract funds, allowing them to "gamble for resurrection" with taxpayer-backed money. This not only exacerbates their own problems but also distorts competition, as healthy banks must compete with institutions operating under a hidden subsidy.

3. Policymakers' Core Motivation: Averting Systemic Instability

Policymakers hope that by preventing spillovers in the financial system they can shield the economy from a significant decline in national output.

Fear of contagion. The primary driver behind TBTF bailouts is policymakers' deep-seated fear that the failure of one large, interconnected bank will trigger a cascade of failures across the financial system, leading to broader economic collapse. This concern is rooted in the unique nature of banks, which are susceptible to runs and play critical roles in the economy.

Mechanisms of spillover: Policymakers identify several pathways for contagion:

• Interbank exposures: Direct unsecured lending between banks, or unsettled positions in payment systems, can mean one bank's failure directly harms others.
• Payment system disruption: A few dominant banks process a vast percentage of payments and securities transactions. Their failure could paralyze critical financial infrastructure.
• Shared exposures: Multiple banks may be vulnerable to the same economic shock (e.g., a regional downturn or a specific asset class), leading to simultaneous distress and widespread loss of confidence.
• Credit crunch: Financial instability can cause banks to curtail lending, particularly to small businesses, stifling economic activity.

The "safe" solution. In the face of such perceived threats, protecting uninsured creditors appears to policymakers as the most immediate and effective way to stabilize the financial system, prevent panic, and maintain essential banking services. While critics argue these fears are often exaggerated or that alternative tools exist, policymakers typically view the short-term benefits of stability as outweighing the long-term costs of moral hazard, making bailouts a seemingly rational, albeit problematic, choice.

4. The Flawed Promise of FDICIA and Similar Reforms

In the long run, however, we predict that the system will not significantly reduce the probability that creditors of TBTF banks will receive bailouts.

FDICIA's intent. The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) was enacted to curb TBTF by mandating a "least-cost" resolution for failed banks, meaning the FDIC must choose the option least expensive to the insurance fund. It also introduced a stringent "systemic risk" exception, requiring high-level approvals from the Treasury, President, Federal Reserve, and FDIC boards for any bailout that deviates from the least-cost test.

Superficial changes. Despite its ambitious goals, FDICIA's core provisions for limiting TBTF protection are unlikely to be effective in the long run. The pre-FDICIA regime already had a "cost test" and an "essentiality" clause that allowed for systemic risk exceptions, often with the implicit involvement of the same high-level officials. The main difference is increased formality and public visibility, which, while not insignificant, may not fundamentally alter the incentives driving bailout decisions.

Credibility deficit. The reforms lack true credibility because they don't address the underlying motivations for bailouts. Policymakers, when confronted with a large bank failure, will still face immense pressure to prevent perceived systemic collapse, and the "systemic risk" exception provides a legal pathway to do so. Furthermore, FDICIA's restrictions on Federal Reserve discount window lending are weak, based on backward-looking capital measures, and impose minimal penalties, suggesting they won't prevent the Fed from propping up troubled institutions when needed.

5. Credibility is Achievable: Lessons from Monetary Policy

Policymakers can take actions to put uninsured creditors at large banks at credible greater risk for loss.

The impossible made possible. The skepticism surrounding TBTF reform mirrors the widespread belief in the late 1970s that double-digit inflation was an intractable, permanent feature of the U.S. economy. Yet, under Paul Volcker's leadership, the Federal Reserve successfully established a credible commitment to price stability, demonstrating that deeply entrenched expectations can be altered through consistent, time-consistent policy.

Volcker's blueprint. The Volcker Fed achieved credibility by:

• Dramatic regime shift: Adopting a monetarist approach and publicly announcing a commitment to wring inflation out of the economy.
• Unwavering resolve: Maintaining restrictive monetary policy despite severe short-term economic costs (recession, high unemployment).
• Consistent action: Aligning words with deeds over an extended period, building trust among market participants.
• Leadership: Volcker's courage and independence were crucial in resisting political pressure.

Applying lessons to TBTF. The monetary policy experience offers a powerful template for TBTF reform. Policymakers can build credibility by:

• Appointing "conservative" leaders: Individuals who prioritize moral hazard costs, possess financial market experience, and have the fortitude to resist bailout pressures.
• Signaling a regime change: Announcing clear, easily monitored reforms that demonstrate a genuine commitment to imposing losses on uninsured creditors.
• Consistent enforcement: Adhering to these new policies even when faced with short-term instability, proving that the commitment is real.

6. Building a Strong Foundation: Deposit Insurance and Fiscal Transparency

Without the rule of law, explicit and implicit government guarantees may be the only way to draw funds into the banking system.

Institutional bedrock. Effective TBTF management requires a robust institutional and legal foundation. Countries need strong rule of law, protected property rights, and transparent public institutions to ensure that financial contracts are enforceable and that government actions are predictable. Without this, implicit guarantees may become the default mechanism for attracting capital, potentially facilitating corruption and misallocation.

Deposit insurance design. The structure of explicit deposit insurance programs significantly impacts TBTF expectations:

• Limited coverage: Well-designed programs restrict coverage by capping amounts, defining covered liabilities, and extending protection primarily to small, unsophisticated depositors.
• Coinsurance: Requiring depositors to bear a portion of losses (e.g., 10-20%) can reintroduce market discipline.
• Context matters: While explicit, limited deposit insurance can reduce moral hazard in countries with strong institutions, it might exacerbate instability in less developed environments.

Budgetary accountability. A critical, often overlooked, reform is to improve government budgeting for contingent liabilities. Cash-based accounting systems obscure the true, long-term costs of implicit TBTF guarantees, creating perverse incentives for policymakers to ignore or postpone addressing potential losses. Moving to an accrual-based system would:

• Recognize costs upfront: Force policymakers to acknowledge the estimated future costs of TBTF exposure as they accrue.
• Improve decision-making: Provide accurate "prices" for government programs, encouraging more prudent management of financial risks.
• Increase transparency: Publicly disclose potential bailout costs, fostering greater accountability and potentially generating public pressure for reform.

7. Reducing Uncertainty: Proactive Planning for Bank Failures

Information gleaned from the simulations of large bank failure should help policymakers to minimize coverage provided to uninsured creditors without creating excessive financial instability.

Scenario planning for crises. Policymakers' uncertainty about the ripple effects of a large bank failure is a key driver of TBTF bailouts. To counter this, supervisors should engage in rigorous scenario planning and stress testing, simulating how the failure of systemically important banks would impact other institutions and markets. This involves:

• Cross-firm exposure analysis: Mapping out interbank liabilities and payment system dependencies.
• Data readiness: Identifying and ensuring access to critical financial data and proprietary models for rapid solvency assessment.
• Resolution simulations: Practicing various resolution options (liquidation, bridge banks) to build confidence in managing complex failures without full bailouts.

Clarifying legal frameworks. Ambiguity in legal and regulatory frameworks exacerbates uncertainty and can trigger runs. Reforms should focus on:

• Standardizing financial contracts: Reducing variability in documentation for complex instruments like derivatives.
• Enforcing closeout netting: Ensuring creditors can quickly terminate and net financial contracts upon default, reducing losses and preventing "cherry-picking" by liquidators.
• Harmonizing international insolvency laws: Addressing conflicts in cross-border resolutions to prevent "ring-fencing" and ensure orderly treatment of multinational bank creditors.

Expediting creditor payments. Delays in returning funds to uninsured creditors after a bank failure can cause panic and pressure for bailouts. Policymakers should:

• Enable advance dividends: Legally authorize and operationally facilitate rapid, conservative payments to uninsured creditors based on estimated liquidation values.
• Improve record-keeping: Mandate robust data management to quickly determine creditor claims. This reduces the financial hardship on creditors and lessens their incentive to run or demand full protection.

8. Limiting Losses: Early Intervention and Creditor Coinsurance

The most direct method of reducing expected losses is to close banks expected to fail while they have sufficient assets to repay creditors in full.

Prompt corrective action (PCA). A fundamental strategy to limit creditor losses and reduce bailout incentives is to close weak banks while they still possess positive capital. Regimes like the U.S. Prompt Corrective Action (PCA) aim to achieve this by mandating escalating supervisory interventions based on a bank's capital levels. However, current PCA systems often rely on backward-looking "book value" capital, which can mask true insolvency.

• Market-based triggers: Shifting to market-based capital triggers would provide more timely and accurate signals of a bank's health, enabling earlier, more effective intervention.
• Reduced discretion: Minimizing supervisory discretion in applying these triggers is crucial for credibility.

Rapid recapitalization. Another approach is to ensure that weakening banks can quickly bolster their capital. Innovative financial instruments, such as debt that automatically converts to equity when a bank approaches insolvency, could provide a rapid, market-driven recapitalization mechanism. While still in early stages of development, such tools could reduce the likelihood of a bank reaching a point where a bailout seems inevitable.

Coinsurance for uninsured. To balance market discipline with stability, governments can implement coinsurance for uninsured creditors. This means that even if a bailout occurs, uninsured creditors would still bear a predetermined percentage of their losses (e.g., 10-25%). This partial loss absorption:

• Reintroduces discipline: Gives creditors a reason to monitor bank risk.
• Limits moral hazard: Prevents the expectation of 100% protection.
• Manages systemic risk: Ensures losses are not so catastrophic as to trigger widespread contagion.

9. Mitigating Payment System Contagion

Eliminating the small time period of exposure would reduce the ability of one bank’s failure to bring down the other.

Payment system vulnerabilities. Payment systems, while essential, can create massive, short-term credit exposures between banks. When one bank sends funds or securities but has not yet received the corresponding payment, it becomes a creditor to its counterparty. If the counterparty fails during this brief window, the first bank faces a potentially devastating loss, triggering spillovers. Daily interbank exposures in foreign exchange alone can exceed $1 trillion.

Successful reforms: Significant progress has been made in reducing these exposures:

• Real-time gross settlement (RTGS): Many countries now use RTGS for large-value payments, settling transactions individually and immediately, virtually eliminating interbank credit risk.
• Payment versus payment (PvP): The CLS Bank, for foreign exchange, ensures that both legs of a currency transaction settle simultaneously, drastically reducing settlement risk.
• Delivery versus payment (DvP): For securities, DvP systems ensure that securities are exchanged for cash concurrently, preventing losses if one party defaults.
• Netting and collateralization: Payment systems increasingly use netting (offsetting mutual obligations) and collateral requirements to reduce the size of potential losses.

Ongoing challenges and trade-offs. While these reforms have reduced credit risk, they can increase liquidity risk, as banks need more intraday funds to settle transactions immediately. Central banks often provide this intraday liquidity, which, if not managed carefully, can create new moral hazard. Policymakers must continue to:

• Monitor reforms: Ensure new systems like CLS Bank are effective and address remaining vulnerabilities in securities settlement.
• Manage central bank credit: Implement caps, pricing, and collateral requirements for central bank intraday credit to mitigate moral hazard.
• Address direct exposures: Consider limits on direct interbank lending and correspondent banking exposures.

10. Strategic Use of Market Discipline and Supervisory Tools

Market discipline should have a more important role in managing bank risk-taking in the future, when governments implement the reforms we discuss, dampen expectations of TBTF protection, and improve the quality of market prices.

Enhancing direct discipline. While direct market discipline is currently insufficient due to TBTF expectations, it can be significantly enhanced. Future reforms should focus on:

• Mandatory disclosure: Requiring banks to provide more transparent, standardized information about their risk-taking. This helps creditors make informed decisions, though its effectiveness is maximized when creditors genuinely believe they face losses.
• Mandatory subordinated debt (SND): Requiring banks to issue uninsured subordinated debt. SND holders, being lower in the creditor hierarchy, have a strong incentive to monitor bank risk and demand higher returns for perceived risk, thereby imposing discipline.

Leveraging indirect discipline. Supervisors can also harness market forces indirectly by incorporating market data into their assessments and actions. This involves:

• Integrating market signals: Using debt market yields, equity-derived default probabilities, and credit derivative spreads to augment traditional supervisory data. Market data offer timely, forward-looking, and independent assessments of bank risk.
• Risk-based deposit insurance premiums: Adjusting insurance premiums based on market-derived risk measures would force banks to internalize the true cost of their risk-taking.
• Market-based triggers for PCA: Using market valuations of capital, rather than historical book values, to trigger prompt corrective actions, ensuring more timely and effective interventions.
• Market value accounting: Shifting to fair value accounting for bank assets and liabilities would provide a more accurate, real-time picture of a bank's solvency, improving both market and supervisory assessments.

A phased approach. While these tools hold great promise, their full potential is realized after the foundational reforms that put creditors at credible risk of loss are in place. A strategic, phased implementation, starting with increased supervisory use of market data and moving towards mandatory SND and market value accounting, will maximize their impact on reducing TBTF.

Last updated: January 9, 2026