The Too Big to Fail Doctrine

Too big to fail (TBTF) is a doctrine postulating that the government cannot allow very big firms (particularly major banks and financial institutions) to fail, for the very reason that they are big. Dabos (2004) argues that TBTF policy is adopted by the authorities in many countries, but it is rarely admitted in public. This doctrine is justified on the basis of systemic risk, the risk of adverse consequences of the failure of one firm for the underlying sector or the economy at large. The concept of TBTF is relevant to financial institutions in particular because it is in the financial sector where we find large and extremely interconnected institutions. For example, some 82 per cent of foreign exchange transactions are conducted by banks with other banks and non-bank financial institutions (Bank for International Settlements, 2007). This is why the failure of one financial institution is bad news for its competitors. In other industries, the failure of a firm is typically good news for other firms in the same industry because it means the demise of a competitor and the inheritance of its market share by existing firms. As we are going to see, size and interconnectedness determine systemic risk, but that is not all. Financial institutions are also politically powerful, which gives them a comparative advantage in the “race” to obtain the TBTF status.