IDEAS home Printed from https://ideas.repec.org/a/anr/refeco/v5y2013p43-61.html
   My bibliography  Save this article

Too Big to Fail: Causes, Consequences, and Policy Responses

Author

Listed:
  • Philip E. Strahan

    (Carroll School of Management, Boston College, Chestnut Hill, Massachusetts 02467
    The National Bureau of Economic Research, Cambridge, Massachusetts 02138)

Abstract

Governments cannot credibly commit to eschew bailouts of creditors when large financial institutions become distressed. This too-big-to-fail (TBTF) problem distorts how markets price securities issued by TBTF firms, thus encouraging them to borrow too much and take too much risk. TBTF also encourages financial firms to grow, leading to competitive inequity and potential misallocation of credit. This review discusses evidence that such distortions are empirically relevant and also discusses the policy efforts to limit them. In the wake of the Financial Crisis of 2007–2008, it seems increased concentration in the financial industry has worsened the TBTF problem. Nevertheless, markets price the risks of large financial firms more now than before the Financial Crisis.

Suggested Citation

  • Philip E. Strahan, 2013. "Too Big to Fail: Causes, Consequences, and Policy Responses," Annual Review of Financial Economics, Annual Reviews, vol. 5(1), pages 43-61, November.
    • Handle: RePEc:anr:refeco:v:5:y:2013:p:43-61
    as

    Download full text from publisher

    File URL: http://www.annualreviews.org/doi/abs/10.1146/annurev-financial-110112-121025
    Download Restriction: Full text downloads are only available to subscribers. Visit the abstract page for more information.
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    References listed on IDEAS

    as
    1. Adam B. Ashcraft, 2005. "Are Banks Really Special? New Evidence from the FDIC-Induced Failure of Healthy Banks," American Economic Review, American Economic Association, vol. 95(5), pages 1712-1730, December.
    2. Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "Varieties of Crises and Their Dates," Introductory Chapters, in: This Time Is Different: Eight Centuries of Financial Folly, Princeton University Press.
    3. Jith Jayaratne & Philip E. Strahan, 1996. "The Finance-Growth Nexus: Evidence from Bank Branch Deregulation," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 111(3), pages 639-670.
    4. Franklin R. Edward, 1999. "Hedge Funds and the Collapse of Long-Term Capital Management," Journal of Economic Perspectives, American Economic Association, vol. 13(2), pages 189-210, Spring.
    5. Markus K. Brunnermeier & Lasse Heje Pedersen, 2009. "Market Liquidity and Funding Liquidity," The Review of Financial Studies, Society for Financial Studies, vol. 22(6), pages 2201-2238, June.
    6. Craig Furfine, 2006. "The Costs and Benefits of Moral Suasion: Evidence from the Rescue of Long-Term Capital Management," The Journal of Business, University of Chicago Press, vol. 79(2), pages 593-622, March.
    7. Donald Morgan & Kevin Stiroh, 2001. "Market Discipline of Banks: The Asset Test," Journal of Financial Services Research, Springer;Western Finance Association, vol. 20(2), pages 195-208, October.
    8. Penas, Maria Fabiana & Unal, Haluk, 2004. "Gains in bank mergers: Evidence from the bond markets," Journal of Financial Economics, Elsevier, vol. 74(1), pages 149-179, October.
    9. Keeley, Michael C, 1990. "Deposit Insurance, Risk, and Market Power in Banking," American Economic Review, American Economic Association, vol. 80(5), pages 1183-1200, December.
    10. Marcin Kacperczyk & Philipp Schnabl, 2010. "When Safe Proved Risky: Commercial Paper during the Financial Crisis of 2007-2009," Journal of Economic Perspectives, American Economic Association, vol. 24(1), pages 29-50, Winter.
    11. Randall S. Kroszner & Philip E. Strahan, 1999. "What Drives Deregulation? Economics and Politics of the Relaxation of Bank Branching Restrictions," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 114(4), pages 1437-1467.
    12. Kroszner, Randall S & Rajan, Raghuram G, 1994. "Is the Glass-Steagall Act Justified? A Study of the U.S. Experience with Universal Banking before 1933," American Economic Review, American Economic Association, vol. 84(4), pages 810-832, September.
    13. Elijah Brewer & Julapa Jagtiani, 2013. "How Much Did Banks Pay to Become Too-Big-To-Fail and to Become Systemically Important?," Journal of Financial Services Research, Springer;Western Finance Association, vol. 43(1), pages 1-35, February.
    14. Kane, Edward J, 1990. "Principal-Agent Problems in S&L Salvage," Journal of Finance, American Finance Association, vol. 45(3), pages 755-764, July.
    15. Flannery, Mark J & Sorescu, Sorin M, 1996. "Evidence of Bank Market Discipline in Subordinated Debenture Yields: 1983-1991," Journal of Finance, American Finance Association, vol. 51(4), pages 1347-1377, September.
    16. Kane, Edward J, 2000. "Incentives for Banking Megamergers: What Motives Might Regulators Infer from Event-Study Evidence?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(3), pages 671-701, August.
    17. Ang, James S. & Richardson, Terry, 1994. "The underwriting experience of commercial bank affiliates prior to the Glass-Steagall Act: A reexamination of evidence for passage of the act," Journal of Banking & Finance, Elsevier, vol. 18(2), pages 351-395, January.
    18. Jayaratne, Jith & Strahan, Philip E, 1998. "Entry Restrictions, Industry Evolution, and Dynamic Efficiency: Evidence from Commercial Banking," Journal of Law and Economics, University of Chicago Press, vol. 41(1), pages 239-273, April.
    19. Reinhart, Karmen & Rogoff, Kenneth, 2009. ""This time is different": panorama of eight centuries of financial crises," Ekonomicheskaya Politika / Economic Policy, Russian Presidential Academy of National Economy and Public Administration, vol. 1, pages 77-114, March.
    20. Tara Rice & Philip E. Strahan, 2010. "Does Credit Competition Affect Small‐Firm Finance?," Journal of Finance, American Finance Association, vol. 65(3), pages 861-889, June.
    21. Randall S. Kroszner, 1999. "Can the Financial Markets Privately Regulate Risk? The Development of Derivatives Clearing Houses and Recent Over-the Counter Innovations," CRSP working papers 493, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
    22. Kroszner, Randall S. & Rajan, Raghuram G., 1997. "Organization structure and credibility: Evidence from commercial bank securities activities before the Glass-Steagall Act," Journal of Monetary Economics, Elsevier, vol. 39(3), pages 475-516, August.
    23. Rajan, Raghuram G & Zingales, Luigi, 1998. "Financial Dependence and Growth," American Economic Review, American Economic Association, vol. 88(3), pages 559-586, June.
    24. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360, October.
    25. Berger, Allen N. & Miller, Nathan H. & Petersen, Mitchell A. & Rajan, Raghuram G. & Stein, Jeremy C., 2005. "Does function follow organizational form? Evidence from the lending practices of large and small banks," Journal of Financial Economics, Elsevier, vol. 76(2), pages 237-269, May.
    26. W. Scott Frame & Lawrence J. White, 2005. "Fussing and Fuming over Fannie and Freddie: How Much Smoke, How Much Fire?," Journal of Economic Perspectives, American Economic Association, vol. 19(2), pages 159-184, Spring.
    27. O'Hara, Maureen & Shaw, Wayne, 1990. "Deposit Insurance and Wealth Effects: The Value of Being "Too Big to Fail."," Journal of Finance, American Finance Association, vol. 45(5), pages 1587-1600, December.
    28. Carmen M. Reinhart & Kenneth S. Rogoff, 2014. "This Time is Different: A Panoramic View of Eight Centuries of Financial Crises," Annals of Economics and Finance, Society for AEF, vol. 15(2), pages 215-268, November.
    29. David C. Wheelock & Paul W. Wilson, 2012. "Do Large Banks Have Lower Costs? New Estimates of Returns to Scale for U.S. Banks," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 44(1), pages 171-199, February.
    30. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, vol. 24(Win), pages 14-23.
    31. Puri, Manju, 1996. "Commercial banks in investment banking Conflict of interest or certification role?," Journal of Financial Economics, Elsevier, vol. 40(3), pages 373-401, March.
    32. Reint Gropp & Hendrik Hakenes & Isabel Schnabel, 2011. "Competition, Risk-shifting, and Public Bail-out Policies," The Review of Financial Studies, Society for Financial Studies, vol. 24(6), pages 2084-2120.
    33. Gande, Amar, et al, 1997. "Bank Underwriting of Debt Securities: Modern Evidence," The Review of Financial Studies, Society for Financial Studies, vol. 10(4), pages 1175-1202.
    34. Randall Kroszner, 2011. "Challenges For Macroprudential Supervision," World Scientific Book Chapters, in: Stijn Claessens & Douglas D Evanoff & George G Kaufman & Laura E Kodres (ed.), Macroprudential Regulatory Policies The New Road to Financial Stability?, chapter 23, pages 379-385, World Scientific Publishing Co. Pte. Ltd..
    35. Berger, Allen N. & Demsetz, Rebecca S. & Strahan, Philip E., 1999. "The consolidation of the financial services industry: Causes, consequences, and implications for the future," Journal of Banking & Finance, Elsevier, vol. 23(2-4), pages 135-194, February.
    36. Daniel Paravisini, 2008. "Local Bank Financial Constraints and Firm Access to External Finance," Journal of Finance, American Finance Association, vol. 63(5), pages 2161-2193, October.
    37. Gorton, Gary & Metrick, Andrew, 2012. "Securitized banking and the run on repo," Journal of Financial Economics, Elsevier, vol. 104(3), pages 425-451.
    38. Elena Loutskina & Philip E. Strahan, 2011. "Informed and Uninformed Investment in Housing: The Downside of Diversification," The Review of Financial Studies, Society for Financial Studies, vol. 24(5), pages 1447-1480.
    39. Markus K. Brunnermeier, 2009. "Deciphering the Liquidity and Credit Crunch 2007-2008," Journal of Economic Perspectives, American Economic Association, vol. 23(1), pages 77-100, Winter.
    40. Carola Schenone, 2004. "The Effect of Banking Relationships on the Firm's IPO Underpricing," Journal of Finance, American Finance Association, vol. 59(6), pages 2903-2958, December.
    41. Mitchell A. Petersen & Raghuram G. Rajan, 2002. "Does Distance Still Matter? The Information Revolution in Small Business Lending," Journal of Finance, American Finance Association, vol. 57(6), pages 2533-2570, December.
    42. Barth, James R. & Prabha, Apanard & Swagel, Phillip, 2012. "Just How Big Is the Too Big to Fail Problem?," Working Papers 12-06, University of Pennsylvania, Wharton School, Weiss Center.
    43. Slovin, Myron B & Sushka, Marie E & Polonchek, John A, 1993. "The Value of Bank Durability: Borrowers as Bank Stakeholders," Journal of Finance, American Finance Association, vol. 48(1), pages 247-266, March.
    44. Milton Friedman & Anna J. Schwartz, 1963. "A Monetary History of the United States, 1867–1960," NBER Books, National Bureau of Economic Research, Inc, number frie63-1, July.
    45. Bernanke, Ben S, 1983. "Nonmonetary Effects of the Financial Crisis in Propagation of the Great Depression," American Economic Review, American Economic Association, vol. 73(3), pages 257-276, June.
    46. Todd A. Gormley & Simon Johnson & Changyong Rhee, 2011. "Ending "Too Big To Fail": Government Promises vs. Investor Perceptions," NBER Working Papers 17518, National Bureau of Economic Research, Inc.
    47. Asim Ijaz Khwaja & Atif Mian, 2005. "Do Lenders Favor Politically Connected Firms? Rent Provision in an Emerging Financial Market," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 120(4), pages 1371-1411.
    48. Demsetz, Rebecca S & Strahan, Philip E, 1997. "Diversification, Size, and Risk at Bank Holding Companies," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 29(3), pages 300-313, August.
    49. Lucas, Deborah & McDonald, Robert L., 2006. "An options-based approach to evaluating the risk of Fannie Mae and Freddie Mac," Journal of Monetary Economics, Elsevier, vol. 53(1), pages 155-176, January.
    50. Avery, Robert B & Belton, Terrence M & Goldberg, Michael A, 1988. "Market Discipline in Regulating Bank Risk: New Evidence from the Capital Markets," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 20(4), pages 597-610, November.
    51. Mr. Manmohan Singh & James Aitken, 2010. "The (Sizable) Role of Rehypothecation in the Shadow Banking System," IMF Working Papers 2010/172, International Monetary Fund.
    52. Hannan, Timothy H & Hanweck, Gerald A, 1988. "Bank Insolvency Risk and the Market for Large Certificates of Deposit," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 20(2), pages 203-211, May.
    53. Kroszner, Randall S, 1999. "Can the Financial Markets Privately Regulate Risk? The Development of Derivatives Clearinghouses and Recent Over-the-Counter Innovations," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 31(3), pages 596-618, August.
    54. Randall S. Kroszner, 1999. "Can the financial markets privately regulate risk? The development of derivatives clearinghouses and recent over-the-counter innovations," Proceedings, Federal Reserve Bank of Cleveland, pages 596-623.
    55. Kanatas, George & Qi, Jianping, 1998. "Underwriting by Commercial Banks: Incentive Conflicts, Scope Economies, and Project Quality," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 30(1), pages 119-133, February.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Gorton, Gary & Winton, Andrew, 2003. "Financial intermediation," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 8, pages 431-552, Elsevier.
    2. Randall S. Kroszner & Philip E. Strahan, 2014. "Regulation and Deregulation of the US Banking Industry: Causes, Consequences, and Implications for the Future," NBER Chapters, in: Economic Regulation and Its Reform: What Have We Learned?, pages 485-543, National Bureau of Economic Research, Inc.
    3. Luc Laeven, 2011. "Banking Crises: A Review," Annual Review of Financial Economics, Annual Reviews, vol. 3(1), pages 17-40, December.
    4. Committee, Nobel Prize, 2022. "Financial Intermediation and the Economy," Nobel Prize in Economics documents 2022-2, Nobel Prize Committee.
    5. Xavier Vives, 2011. "Competition and Stability in Banking," Central Banking, Analysis, and Economic Policies Book Series, in: Luis Felipe Céspedes & Roberto Chang & Diego Saravia (ed.),Monetary Policy under Financial Turbulence, edition 1, volume 16, chapter 12, pages 455-502, Central Bank of Chile.
    6. Beck, T.H.L., 2011. "The Role of Finance in Economic Development : Benefits, Risks, and Politics," Discussion Paper 2011-141, Tilburg University, Center for Economic Research.
    7. Randall Kroszner, 2016. "A Review of Bank Funding Cost Differentials," Journal of Financial Services Research, Springer;Western Finance Association, vol. 49(2), pages 151-174, June.
    8. Fratianni, Michele & Giri, Federico, 2017. "The tale of two great crises," Journal of Economic Dynamics and Control, Elsevier, vol. 81(C), pages 5-31.
    9. Hett, Florian & Schmidt, Alexander, 2017. "Bank rescues and bailout expectations: The erosion of market discipline during the financial crisis," Journal of Financial Economics, Elsevier, vol. 126(3), pages 635-651.
    10. Liangliang Jiang & Ross Levine & Chen Lin, 2023. "Does Competition Affect Bank Risk?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 55(5), pages 1043-1076, August.
    11. Goetz, Martin R. & Laeven, Luc & Levine, Ross, 2016. "Does the geographic expansion of banks reduce risk?," Journal of Financial Economics, Elsevier, vol. 120(2), pages 346-362.
    12. Michalski, Tomasz & Ors, Evren, 2012. "(Interstate) Banking and (interstate) trade: Does real integration follow financial integration?," Journal of Financial Economics, Elsevier, vol. 104(1), pages 89-117.
    13. Berger, Allen N. & Molyneux, Phil & Wilson, John O.S., 2020. "Banks and the real economy: An assessment of the research," Journal of Corporate Finance, Elsevier, vol. 62(C).
    14. Jiang, Tianjiao & Levine, Ross & Lin, Chen & Wei, Lai, 2020. "Bank deregulation and corporate risk," Journal of Corporate Finance, Elsevier, vol. 60(C).
    15. Ebrahimi Kahou, Mahdi & Lehar, Alfred, 2017. "Macroprudential policy: A review," Journal of Financial Stability, Elsevier, vol. 29(C), pages 92-105.
    16. Carletti, Elena & Ongena, Steven & Siedlarek, Jan-Peter & Spagnolo, Giancarlo, 2021. "The impacts of stricter merger legislation on bank mergers and acquisitions: Too-Big-To-Fail and competition," Journal of Financial Intermediation, Elsevier, vol. 46(C).
    17. Berger, Allen N. & Demsetz, Rebecca S. & Strahan, Philip E., 1999. "The consolidation of the financial services industry: Causes, consequences, and implications for the future," Journal of Banking & Finance, Elsevier, vol. 23(2-4), pages 135-194, February.
    18. Calomiris, Charles W. & Nissim, Doron, 2014. "Crisis-related shifts in the market valuation of banking activities," Journal of Financial Intermediation, Elsevier, vol. 23(3), pages 400-435.
    19. Brunnermeier, Markus K. & Oehmke, Martin, 2013. "Bubbles, Financial Crises, and Systemic Risk," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, volume 2, chapter 0, pages 1221-1288, Elsevier.
    20. Masami Imai & Seitaro Takarabe, 2009. "Bank Integration and Local Credit Cycle:Evidence from Japan," Wesleyan Economics Working Papers 2009-002, Wesleyan University, Department of Economics.

    More about this item

    Keywords

    bank risk; too big to fail;

    JEL classification:

    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:anr:refeco:v:5:y:2013:p:43-61. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: http://www.annualreviews.org (email available below). General contact details of provider: http://www.annualreviews.org .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.