Quick definition Too big to fail (TBTF) refers to large financial institutions whose failure would cause systemic damage. Governments must rescue them to prevent financial collapse. What it is Lehman Brothers was allowed to fail in 2008, causing widespread damage. Too-big-to-fail institutions (like AIG, Goldman Sachs, JPMorgan) were rescued because their failure would have been catastrophic. TBTF creates a problem: if institutions know they will be rescued, they have incentives to take excessive risk. Why avoid risk if failure is bailed out? Moral hazard Moral hazard is the problem TBTF creates. Institutions take more risk knowing they will be rescued. Taxpayers bear the downside while institutions enjoy the upside. Regulators try to limit TBTF by: - Requiring larger capital buffers - Limiting leverage - Breaking up large institutions - Creating resolution authority Regulatory response Post-2008 reforms aimed to address TBTF: - Dodd-Frank Act in the US - Basel III capital requirements - Liquidity requirements - Stress testing Despite reforms, the largest banks are still too big to fail. Practical example A major bank takes excessive risk. Losses mount and the bank is near failure. Regulators and the Federal Reserve step in with liquidity and capital infusions, preventing failure. The bank survives but taxpayers bear the cost. The bank's executives keep their jobs and the bank continues risk-taking. Criticisms TBTF is widely criticised as unfair and dangerous. It creates inequality (large firms are rescued; small firms go bankrupt) and reduces market discipline. See also - Systemic Risk - Moral Hazard - Bailout - Regulatory Capital
