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What Does “Too Big to Fail” Mean?
In America, size matters. But bigger isn’t always better when it comes to its businesses.
Sometimes a company grows so large and becomes such an integral part of an economy that when it’s in distress, the risk of losing it outweighs the cost of supplying emergency resources to help keep it afloat. That is the premise behind “too big to fail.”
A Brief History of the Phrase “Too Big to Fail”
Connecticut Congressman Stewart McKinney coined the phrase “too big to fail” in 1984. He was part of the House Subcommittee on Banking, Finance, and Urban Affairs that was investigating a banking crisis at Continental Illinois National Bank and Trust Company, the highest-profile bank to experience a bank failure since the Federal Deposit Insurance Corporation (FDIC) was established in 1933.
Headquartered in Chicago, Continental Illinois enjoyed rapid growth in the 1970s, mainly through oil and gas loans. Oil prices had catapulted from $2.75 per barrel in 1973 to $36.95 per barrel in 1981, creating a boom for energy, particularly in the American Southwest, as banks rushed to provide credit to energy-related businesses.
As global tensions eased and oil supply shocks abated, what went up came crashing back down. Oil production resumed, and prices declined. One of Continental Illinois’ major trading partners, the Oklahoma-based Penn Square Bank, declared insolvency in 1982; it had sold $326 million worth of risky energy loans to Continental Illinois. Desperate for liquidity, the bank turned to even riskier funding sources, such as the Eurodollar money markets. By 1984, only 15% of Continental Illinois’ liabilities were made up of insured deposits.
Sensing danger, customers of Continental Illinois demanded their money back, sparking a bank run on May 7, 1984. The bank lost $10 billion (30% of its assets) in just 10 days before being placed under financial receivership by the Federal Deposit Insurance Corporation (FDIC).
Since Continental Illinois was so large, if they had let it fail, the Federal Reserve surmised, there would be widespread financial contagion, causing many other banks to collapse as a result. Continental Illinois was considered a leader in the Midwest, providing services to more than 180 other banks and countless small businesses. And so, the Fed made an unprecedented gesture: It guaranteed all of the bank’s depositors—even uninsured accounts, accounts above the $100,000 maximum, and bondholders. This showcased for the first time the lengths the Fed would go to in order to ensure the financial system’s stability.
Continental Illinois was “bailed out” in several other ways:
- It received a $2 billion emergency loan from the Fed’s discount window.
- 16 large banks, led by Morgan Guaranty, a subsidiary of JPMorgan Chase, offered the troubled bank a $4.5 billion line of credit.
- The FDIC later provided $7.5 billion in additional aid and eventually assumed an 80% stake in the bank after failing to secure an acquisition for it.
But not everyone applauded this outpouring of assistance. Members of Congress, who, after all, are liable to the U.S. taxpayer, were furious. The House Subcommittee Chairman, Fernand St. Germain, complained how, for years, his committee had been monitoring these kinds of banking disasters and “in an uphill battle against banking lobbyists” were able to create new regulatory authorities, powers that were now proving useless.
Congressman McKinney added, “It seems to me that regulators have decided that, in fact, a bail-out may be conducted without the consent of those who are going to pay the bill and without stringent requirements and regulations that we put on those other Federal assistance bills.” He continued, “In fact, it is with great interest I note that the regulators have decided that the very people who issued those rotten loans will now manage them …”
“… Let us not bandy words. We have a new kind of bank. It is called too big to fail. TBTF, and it is a wonderful bank.”
—Congressman Stewart McKinney, October 1984
The phrase “too big to fail,” uttered by Congressman McKinney, was taken as derogatory. If banks’ misdeeds were left unpunished, others argued, wouldn’t that free them up to take even bigger and bolder risks?
Why Is “Too Big to Fail” Important?
The Financial Crisis of 2007–2008 arguably added even greater significance to the term “too big to fail” as behemoths in multiple business sectors threatened to topple like dominoes.
The source of this global crisis was toxic U.S. housing loans. Many of these loans were risky, subprime mortgages with adjustable rates that started out cheap but quickly shot up by hundreds of dollars or more per month. Poorly explained and often sold by predatory lenders, these mortgages were often misunderstood by many homeowners who couldn’t afford the higher rates. When all was said and done (around August of 2008), nearly 10% of homes across the U.S. had entered foreclosure.
But the problem didn’t end there. Banks had collateralized these home loans and sold them to investment banks; the highest-yielding securities also contained the most volatile subprime mortgages. Upon their implosion, massive losses seeped through every level of the financial industry. New Century Financial Corp, one of the country’s biggest mortgage lenders, filed for bankruptcy. Big government housing agencies, like Fannie Mae and Freddie Mac, entered financial receivership.
Then Lehman Brothers, one of the world’s largest banks with assets of $600 billion, declared bankruptcy on September 15, 2008.
Dominoes That Were Threatening to Topple in 2008
| Company | 2008 Assets |
|---|---|
Bear Stearns |
$400 billion |
Lehman Brothers |
$600 billion |
Merrill Lynch |
$655 billion |
Goldman Sachs |
$868 billion |
Morgan Stanley |
$900 billion |
Bank of America |
$1.5 trillion |
JP Morgan Chase |
$2 trillion |
Several of the other big banks were also in big trouble. These banks were all considered “too big to fail” because they were so interconnected; insolvency at one, and the entire financial system could collapse, so regulators rushed to provide emergency assistance or facilitate acquisitions at firesale prices.
Eventually, Bear Stearns was sold to JP Morgan, while Merrill Lynch was acquired by Bank of America. Goldman Sachs and Morgan Stanley received huge infusions of emergency aid from the federal government.
On September 28, 2008, lawmakers initially vetoed a bill that would “bail out” or send taxpayer assistance to the financial industry; as a result, the stock market crashed the next day—September 29, 2008‚—ushering in a 2-year recession that became known as the Great Recession, as its severity was rivaled only by the Great Depression.
In October of 2008, Congress approved a $700 billion “bailout” of the stock market through the Troubled Asset Relief Program (TARP). Yet financial giants weren’t the only ones considered “too big to fail.” A quickly deteriorating economy spelled dire consequences for the U.S. automotive industry, and General Motors and Chrysler announced that without federal aid, they would have to cut 1 million jobs. They received a combined $17.4 billion in December of 2008.
What Is the Moral Hazard of Too Big to Fail?
Bailouts are temporary fixes that often leave permanent damage. In a capitalistic economy, why should one business receive undue privileges, emergency assistance, or other forms of “free money?” Without facing the consequences of its actions, that business only becomes more emboldened to take even greater risks.
The Dodd-Frank Wall Street Reform and Consumer Protection Act, passed by then-President Obama and the U.S. Congress in 2010, made sweeping reforms to stem the excessive risk-taking that resulted in the Financial Crisis of 2007–2008. It created a Financial Stability Oversight Council to literally break apart banks that were becoming “too big.”
Under the Volcker Rule, banks were prohibited from trading high-yield derivatives, like collateralized mortgage obligations. The FDIC also received new tools to lend emergency credit to troubled institutions—credit that wasn’t taxpayer funded.
Speaking to the Institute of International Bankers in 2013, then Fed-Governor Jerome Powell said, “It is worth noting that too big to fail is not simply about size. A big institution is ‘too big’ when there is an expectation that the government will do whatever it takes to rescue that institution from failure, thus bestowing an effective risk premium subsidy.”
He went on to propose that, ultimately, the government’s reforms need to prevent systemic failures from happening in the first place.
However, by 2018, then-President Donald Trump had rolled back several key Dodd-Frank mandates, including one that increased the threshold on what would be considered to be “too big to fail” from $50 billion to $250 billion in assets.
Some have argued that this added subterfuge to regional banks’ balance sheets and helped to foster the banking crisis of 2023, during which Silicon Valley Bank, Signature Bank, and First Republic Bank failed within a six-week stretch in the spring of 2023.
