Blog: Charting Progress on Too Big To Fail

By Sean Campbell, Director of Policy Research

A decade ago, the financial crisis raised important policy questions about how to end “too big to fail,” or “TBTF.”  By TBTF we mean a situation in which a bank is so large, complex, or interconnected with the financial system that the government is unwilling to allow the bank to fail for fear that its failure would impose too much damage on the economy.  Consequently, governments take extraordinary actions to avoid the default of a TBTF bank.  As a result, creditors are protected from default losses and fund a TBTF bank more cheaply than if they were exposed to the possibility of default losses.  In this post, we describe some of the most significant changes to large banks and the financial system that directly address TBTF.

In the past decade, three broad sets of changes have been made to address TBTF.  First, large banks have taken significant steps to reduce their complexity and improve their ability to fail without significant knock-on effects to the rest of the economy.  Second, the legal and regulatory regime has undergone material changes to facilitate a less costly failure and more effective resolution of a large bank.  Third, public transparency around the government’s unwillingness to provide extraordinary support in the event of a future failure scenario has increased markedly.  As a consequence of these three changes, bank creditors have realized that they bear default risk, and the cost of funding large banks has increased as a result.  Taken together, these developments point to a world in which large banks and large bank creditors would be required to deal privately with the consequences of failure.

Steps Taken by Banks to Improve Resolvability

First and foremost, large banks, and Forum members in particular, have made significant strides in reducing their overall complexity and making resolution more feasible.  All Forum members engage in an ongoing resolution, or “living will,” process.  Resolution plans detail a bank’s most significant and material operating entities as well as funding sources, liquidity sources, and roadmaps for the wind-down and sale or disposal of certain legal entities and assets in the event of failure.  Forum members’ living wills are reviewed and assessed by the Federal Reserve and FDIC.  As of the most recent review in December, all Forum members’ resolution plans have met regulatory requirements.

While the living will process is crucial to dealing with TBTF, other steps have been taken by Forum members to reduce complexity and make themselves resolvable.  To that point, two important changes have been made over the past decade.

First, Forum members have reduced their organizational complexity.  A simpler and less complex organization is easier to resolve than a more complex organization.  Figure 1 displays one measure of organizational complexity that is explored in research conducted by the Federal Reserve Bank of New York: the total number of legal subsidiaries within a holding company.  As shown in Figure 1, total Forum member subsidiaries have declined by roughly 50% since 2009, which suggests a significant decrease in organizational complexity.

Source: FFIEC National Information Center, HC > $10B Organizational Hierarchy, https://www.ffiec.gov/nicpubweb/nicweb/HCSGreaterThan10B.aspx

 

Second, Forum members have reduced their balance sheet complexity by reducing their holdings of complex and illiquid assets.  Banks with simpler balance sheets are easier to resolve, as selling complex and hard-to-value assets is time consuming, costly, and challenging.   Figure 2 presents the total amount of Level III assets held by Forum members since 2009.  Level III assets are those assets that can only be valued for accounting purposes by reference to complex quantitative models.  Collateralized debt obligations, or so-called “CDOs,” and “CDO-squareds” would be examples of assets that would be identified as Level III assets.  As shown in Figure 2, Forum members have reduced their Level III assets by 77% since 2009, which indicates a significant reduction in balance sheet complexity.  The evidence presented in Figures 1 and 2 provide concrete evidence that Forum members have reduced both their organizational and balance sheet complexity, which has improved their resolvability.

Source: FR Y-9C data, available at https://www.ffiec.gov/nicpubweb/nicweb/HCSGreaterThan10B.aspx

 

Changes to the Legal and Regulatory Framework

Aside from the organizational changes that have been made by large banks to improve their resolvability, the government and regulators have made significant changes to the legal and regulatory system to facilitate an orderly and cost-effective resolution.  Importantly, the Dodd-Frank Act created a new backup resolution regime that is designed to facilitate the resolution of a large financial firm while limiting spillover costs to the rest of the economy.  Under this new backup regime, the material operating subsidiaries of the holding company, such as the bank, would continue operating normally as holding company debt holders would see their debt instruments converted into equity in the material operating subsidiaries.  This new resolution regime has been endorsed by key regulators.  In 2013, Federal Reserve Board Chairman (then Governor) Jay Powell supported the new resolution regime: “I came around to the view that it is possible to resolve a large, global financial institution.  What changed my mind was the FDIC’s innovative ‘single-point-of-entry’ approach…this approach is a classic simplifier, making theoretically possible something that seemed impossibly complex.”

One key pre-condition to a successful resolution under the new regime is that the financial institution in question have sufficient amounts of long-term debt that can be converted to equity.  In December 2016, the Federal Reserve Board adopted specific long-term debt requirements to facilitate a successful resolution.  As of today, all Forum members have issued significant amounts of long-term debt and are on track to comply with the new long-term debt requirements by the rule’s effective date.  To the extent that the creation of a new resolution regime creates the legal basis for an effective and lower cost resolution, the long-term debt issued by Forum members ensures that sufficient financial resources exist to successfully execute a resolution.  Together, the new resolution regime and the existence of significant amounts of long-term debt help ensure the viability of an effective and credible resolution regime for large banks.

Public Transparency and Creditor Recognition

While it is imperative that large banks and the regulatory regime make changes to facilitate an orderly and credible resolution, it is also important that these developments be made abundantly transparent so that creditors and the public fully understand that failure and resulting default losses – no matter how remote – is a distinct possibility.  A number of developments in the past several years have raised public awareness regarding the unlikely nature of any future government support in the event of a large bank failure.

In 2013, a number of credit rating agencies either removed or reduced any rating “uplift” to Forum member bonds that previously existed because of those rating agencies’ assessments that creditors would be supported by extraordinary government actions.  Later, in 2015, rating agencies, such as Standard and Poor’s, publicly announced that as a result of progress made toward establishing a credible resolution regime, the likelihood of any U.S. government extraordinary support was “uncertain,” and the rating on Forum members’ holding company debt was lowered to reflect the greater default risk to private creditors.  Government officials have also opined on the possibility of providing future public support.  In his confirmation hearing in November, Chairman Powell was asked whether big U.S. banks were still “too big to fail.”  In response, Chairman Powell indicated that much progress had been made on the TBTF front.  When pressed further on the question, Chairman Powell answered crisply and directly – “I would say no.”

Despite substantial changes to large banks, the legal framework, and public transparency, one can still reasonably ask whether bank creditors truly understand the risks they face.  Indeed, a key weakness identified during the last financial crisis was a widespread lack of appreciation for risks that, in hindsight at least, seemed apparent to many.  Two recent research papers strongly suggest that investors are aware of these risks.  Darrell Duffie of Stanford University examines the credit spread paid by large banks to their creditors using Credit Default Swap (CDS) spread data.  This credit spread is depicted in Figure 3 and is taken directly from Professor Duffie’s research.  The chart shows that large bank credit spreads have increased from roughly five- to ten-hundredths of a percentage point a decade ago to roughly fifty-hundredths (or one-half) of one percentage point today.  This five- to ten-fold increase is substantial and presents clear evidence that large bank creditors understand the risks they face and charge accordingly.  As Professor Duffie puts it: “Whether or not bail-in [orderly resolution] works reasonably well in practice, what matters for big bank borrowing costs is that creditors believe that it would be tried.  It appears that they do now believe this.  As shown…the cost of wholesale unsecured credit for the largest banks has increased dramatically, despite the significant improvements in capital and liquidity achieved under the post-crisis regulations.”  In particular, Professor Duffie rightly observes that, in light of the significant post-crisis increases in capital and liquidity, one would naturally expect large bank borrowing costs to go down.  The fact that they have actually gone up strongly signals that bank creditors understand and require compensation for the failure risks they face.

Source: Darrel Duffie “Prone to Fail: The Pre-Crisis Financial System,” https://www.darrellduffie.com/uploads/policy/Duffie-JEP-Prone-to-Fail-July7-2018.pdf

 

Another recent research paper by economists at the Federal Reserve Bank of New York examines the change in funding costs following the onset of the previously described living will requirements.  The results of the authors’ findings for Forum members are presented in Table 1, which shows that the onset of living will requirements increased the cost of funding to Forum members by, on average, four-tenths of one percentage point, which amounts to an annual increase in funding costs of nearly $37 billion, which the authors argue is economically significant.  Accordingly, recent research clearly suggests that investors are keenly aware of, and are charging large banks for, the risks they face.  In this sense, large bank and government efforts to directly address TBTF have been successful.

Source: New York Federal Reserve “Resolving too Big to Fail,” https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr859.pdf

 

Conclusion

In the past 10 years, a number of developments have directly addressed the TBTF problem.  Forum members have reduced their complexity and made themselves more resolvable.  The government and regulators have improved the legal and regulatory regime to better facilitate a less costly and more effective resolution.  The public has become increasingly aware that private creditors –  not the government – will be responsible for losses in a future resolution, which has increased the compensation creditors demand to bear default risk.  All of these developments provide clear evidence that the “rules of the road” in the financial system have changed for the better in a way that is well understood by large banks, the government, and the public.

 

Learn More:

The Value and Strength of America’s Largest Financial Institutions

Our institutions support economic growth and a number of steps have led to a more resilient financial sector. Learn more in our briefing slide deck.