Writing Assignment #2 – “Too Big To Fail”
In the 1930s the United States was hit by far the worst financial crisis that it has ever encountered, which was called The Great Depression, but the second worst was not that long ago. During the Financial Crisis of 2007-2009 the United States had a chain of banking failures and a tremendous growth of liability in the federal budget. However, the government had stepped in to prevent some of these failures and through this the concept of “Too Big To Fail” arose once again.
“Too Big To Fail” is a concept where a business or financial institution has become so large and embedded in the nations economy that it would cause a catastrophic ripple effect throughout the economy if it were to fail. However, a government will deliver support and guidance to prevent theses fine businesses and financial institutions from failure. If a company that is considered a “too big to fail” company has problems within the company or from outside the company the government will be lured into saving it through a bailout or by a guarantee of specific loans or if a private company will arise and take over the company. Government bailouts might help the company continue their services; however, various counterparties think that government bailouts are counterproductive and should simply be company to fail.
Along with the concept of “too big to fail” there are risks that come along with it. Rivals against the concept of “too big to fail” consider moral hazard a risk, which is a type of a situation where one party will have the inclination to take risks because that party will not be hit by the costs will be saved by the government. Also, the company that benefits from the protective regulations that come with being a “too big to fail” company will seek a profit, so that they can purposely take positions that are high-risk and give high return. For example, if creditors think that a financial institution will not be allowed to fail, which the leads to not demanding as much compensation that comes with the risk that is being taken. This causes a reduction in market regulation and companies will not invest many resources in checking the firm’s risk. Furthermore, firms will take more risk than needed because they have the expectation that they will be helping if the odds do not go in their favor. Another risk that is created through “too big to fail” firms that it creates an uneven competition amongst the big and small firms. If there is a missing of resolution tools, then firms themselves begin to become a risk to the overall financial stability of an economy.
Even though there are many risks and problems with “too big to fail” companies, there are benefits that come with them too. For example, larger institutions can offer more products and they are more knowledgeable in diversifying risk. The five largest banks had a .31% advantage over smaller institutions through the 2007-2009 financial crisis. This is a significant increase...