Systemically Important or “Too Big to Fail”
Financial Institutions
Marc Labonte
Specialist in Macroeconomic Policy
August 8, 2014
Congressional Research Service
7-5700
www.crs.gov
R42150
Systemically Important or “Too Big to Fail” Financial Institutions
Summary
Although “too big to fail” (TBTF) has been a perennial policy issue, it was highlighted by the
near-collapse of several large financial firms in 2008. Financial firms are said to be TBTF when
policy makers judge that their failure would cause unacceptable disruptions to the overall
financial system, and they can be TBTF because of their size or interconnectedness. In addition to
fairness issues, economic theory suggests that expectations that a firm will not be allowed to fail
create moral hazard—if the creditors and counterparties of a TBTF firm believe that the
government will protect them from losses, they have less incentive to monitor the firm’s riskiness
because they are shielded from the negative consequences of those risks. If so, they could have a
funding advantage compared with other banks, which some call an implicit subsidy. S.Con.Res.
8, passed by the Senate on March 22, 2013, and H.Con.Res. 25, as amended and passed by the
Senate on October 16, 2013, create a non-binding budget reserve fund that allows for future
legislation to address the TBTF funding advantage.
There are a number of policy approaches—some complementary, some conflicting—to coping
with the TBTF problem, including providing government assistance to prevent TBTF firms from
failing or systemic risk from spreading; enforcing “market discipline” to ensure that investors,
creditors, and counterparties curb excessive risk-taking at TBTF firms; enhancing regulation to
hold TBTF firms to stricter prudential standards than other financial firms; curbing firms’ size
and scope, by preventing mergers or compelling firms to divest assets, for example; minimizing
spillover effects by limiting counterparty exposure; and instituting a special resolution regime for
failing systemically important firms. A comprehensive policy is likely to incorporate more than
one approach, as some approaches are aimed at preventing failures and some at containing fallout
when a failure occurs.
Parts of the Wall Street Reform and Consumer Protection Act (Dodd-Frank Act; P.L. 111-203)
address all of these policy approaches. For example, it created an enhanced prudential regulatory
regime administered by the Federal Reserve for non-bank financial firms designated as
“systemically important” by the Financial Stability Oversight Council (FSOC) and bank holding
companies with more than $50 billion in assets. About 30 bank holding companies have assets
more than $50 billion, and the FSOC has designated two insurers (AIG and Prudential) and GE
Capital. In addition, eight banks headquartered in the United States will be assessed capital
surcharges under Basel III. H.R. 4881, ordered to be reported by the House Financial Services
Committee on June 20, 2014, would place a one-year moratorium on FSOC designations. H.R.
5016, which passed the House on July 16, 2014, would not allow any funds to be used to
designate a non-bank as systemically important or as posing a systemic threat to financial
stability.
The Dodd-Frank Act also created a special resolution regime administered by the Federal Deposit
Insurance Corporation to take into receivership failing firms that pose a threat to financial
stability. This regime has not been used to date, and has some similarities to how the FDIC
resolves failing banks. Statutory authority used to prevent financial firms from failing during the
crisis has either expired or been narrowed by the Dodd-Frank Act.
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Systemically Important or “Too Big to Fail” Financial Institutions
Contents
Introduction ...................................................................................................................................... 1
Economic Issues .............................................................................................................................. 2
Context ...................................................................................................................................... 2
Economic Effects of Too Big to Fail ......................................................................................... 4
Do TBTF Firms Enjoy a Funding Advantage or Implicit Subsidy? .................................... 7
Policy Options ................................................................................................................................. 8
Policy Before and During the Crisis .......................................................................................... 8
Policy Options and the Policy Response After the Crisis ........................................................ 10
End or Continue “Bailouts”? ............................................................................................. 11
Limiting the Size of Financial Firms ................................................................................. 15
Limiting the Scope of Financial Firms .............................................................................. 17
Regulating TBTF ............................................................................................................... 20
Minimize Spillover Effects ............................................................................................... 26
Resolving a Large, Interconnected Failing Firm ............................................................... 27
Selected Legislation in the 113th Congress .................................................................................... 32
Conclusion ..................................................................................................................................... 35
Tables
Table 1. Large Financial Firms’ Share of Total Industry Revenue, 1997-2007 ............................... 4
Table 2. U.S. Banks Identified as G-SIBs and Capital Surcharge Recommended by the
FSB ............................................................................................................................................. 25
Appendixes
Appendix. Selected Historical Experience With “Too Big To Fail” .............................................. 38
Contacts
Author Contact Information........................................................................................................... 57
Acknowledgments ......................................................................................................................... 57
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Systemically Important or “Too Big to Fail” Financial Institutions
Introduction
Although “too big to fail” (TBTF) has been a perennial policy issue, it was highlighted by the
near-collapse of several large financial firms in 2008. Large financial firms that failed or required
extraordinary government assistance in the recent crisis included depositories (Citigroup and
Washington Mutual), government-sponsored enterprises (Fannie Mae and Freddie Mac),
insurance companies (AIG), and investment banks (Bear Stearns and Lehman Brothers).1 In many
of these cases, policy makers justified the use of government resources on the grounds that the
firms were “systemically important” or “too big to fail.” TBTF is the concept that a firm’s
disorderly failure would cause widespread disruptions in financial markets that could not easily
be contained. While the government had no explicit policy to rescue TBTF firms, several were
rescued on those grounds once the crisis struck. TBTF subsequently became one of the systemic
risk issues that policy makers grappled with in the wake of the recent crisis.
Systemic risk mitigation, including eliminating the TBTF problem, was a major goal of the Dodd-
Frank Wall Street Reform and Consumer Protection Act (P.L. 111-203), comprehensive financial
regulatory reform enacted in 2010.2 Different parts of this legislation jointly address the “too big
to fail” problem through requirements for enhanced regulation for safety and soundness for
“systemically important” (also called “systemically significant”) financial institutions (SIFIs),
limits on size and the types of activities a firm can engage in (including proprietary trading and
hedge fund sponsorship), and the creation of a new receivership regime for resolving failing non-
banks that pose systemic risk.
About 30 banks will automatically be subject to enhanced regulation because they have at least
$50 billion in assets. In addition, the Financial Stability Oversight Council (FSOC), a council of
U.S. regulators headed by the Treasury Secretary,3 has designated two insurers (AIG and
Prudential) and one other non-bank (GE Capital) as “systemically important,” and therefore
subject to heightened prudential regulation.4 One other insurer (MetLife) is reportedly under
consideration.5 H.R. 4881, ordered to be reported by the House Financial Services Committee on
June 20, 2014, would place a one-year moratorium on FSOC designations of non-banks as
systemically important upon enactment. The Financial Services and General Government
Appropriations Act of 2014 (H.R. 5016), which passed the House on July 16, 2014, would not
allow any funds to be used to designate a non-bank as systemically important or as posing a
systemic threat to financial stability.
1 For more information, see CRS Report R41073, Government Interventions in Response to Financial Turmoil, by
Baird Webel and Marc Labonte.
2 For an overview, see CRS Report R41350, The Dodd-Frank Wall Street Reform and Consumer Protection Act:
Background and Summary, coordinated by Baird Webel. For more information on systemic risk provisions, see CRS
Report R41384, The Dodd-Frank Wall Street Reform and Consumer Protection Act: Systemic Risk and the Federal
Reserve, by Marc Labonte.
3 For more information on the FSOC, see CRS Report R42083, Financial Stability Oversight Council: A Framework to
Mitigate Systemic Risk, by Edward V. Murphy.
4 Information on designated firms can be accessed here: http://www.treasury.gov/initiatives/fsoc/designations/Pages/
default.aspx.
5 Danielle Douglas, “Insurer Appeals Regulatory Label, Enters Uncharted Legal Realm,” July 4, 2013, p. A14; Michael
Crittenden and Leslie Scism, “MetLife Moves Closer to Risk Designation,” Wall Street Journal, July 17, 2013, p. C3.
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In addition, the Financial Stability Board, an international forum, has identified 29 banks, 8 of
which are headquartered in the United States, as “globally systemically important banks” (G-
SIBs) and 9 insurers as “globally systemically important insures,” 3 of which are headquartered
in the United States.6 Under the Basel III Accord, banks identified by the Financial Stability
Board as systemically important are subject to higher capital standards, including a higher
supplementary leverage ratio.
Ultimately, the failure of a large firm is the only test of whether the TBTF problem still exists. In
the meantime, studies have found mixed evidence as to whether large financial firms can still
borrow at advantageous rates compared with other firms because investors—rightly or wrongly—
perceive that they enjoy TBTF status.7 S.Con.Res. 8, passed by the Senate on March 22, 2013,
and H.Con.Res. 25, as amended and passed by the Senate on October 16, 2013, create a non-
binding budget reserve fund that allows for future legislation to address the TBTF funding
advantage. Some critics argue that this legislation does not go far enough to solve the TBTF
problem, and others argue it will have the perverse effect of exacerbating the TBTF problem.
There has not yet been legislation enacted to reform Fannie Mae and Freddie Mac, which remain
in government receivership.
This report discusses the economic issues raised by TBTF, the historical experience with TBTF
before and during the recent crisis, broad policy options, and policy changes made by the relevant
Dodd-Frank provisions. This report also discusses recent legislation addressing the TBTF issue in
the 113th Congress.
Economic Issues
Context
Evidence on the size of financial firms can be viewed in absolute and relative terms—relative to
other industries and within the industry (i.e., concentration). In the first quarter of 2014, there
were 39 U.S. banks with more than $50 billion in assets, of which 4 had more than $1.5 trillion in
assets. Ten years earlier, there was only one U.S. bank with more than $1 trillion in assets.8
In recent decades, the U.S. banking industry has become more concentrated, meaning that a
greater percentage of total industry assets is held by large banks. Assets of the five largest bank
holding companies (BHCs) totaled 52% of total BHC assets at the end of 2013.9 According to one
6 Financial Stability Board, “2013 Update of Global Systemically Important Banks,” November 11, 2013,
http://www.financialstabilityboard.org/publications/r_131111.pdf; Financial Stability Board, “Global Systemically
Important Insurers and the Policy Measures That Will Apply to Them,” July 18, 2013,
http://www.financialstabilityboard.org/publications/r_130718.pdf. The Financial Stability Board is an international
forum of which the United States is a member. A list of the U.S. firms can be found in the section below entitled
“Regulating TBTF.”
7 See, for example, Government Accountability Office, Large Bank Holding Companies – Expectations of Government
Support, GAO-14-621, July 2014.
8 Data from National Information Center, http://www.ffiec.gov/nicpubweb/nicweb/Top50Form.aspx. This list includes
any type of institution that includes a depository subsidiary. These data exaggerate changes in the relative importance
of large banks since they do not take into account inflation or growth in the economy.
9 Federal Reserve Bank of Chicago, Top Banks and Holding Companies, period ending December 31, 2012, available
at http://www.chicagofed.org/webpages/banking/financial_institution_reports/top_banks_bhcs.cfm. In addition, the top
(continued...)
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study, the three largest banks held 5% to 15% of total commercial banking depository assets from
the 1930s until the 1990s. The share of the top three then rose until it had reached about 40% by
2008.10 By international standards, U.S. banks are not that large, however. Relative to GDP, the
combined assets of the top three U.S. banks were the lowest of any major OECD economy in
2009.11
The four largest BHCs each held a majority of their assets in commercial bank subsidiaries. Not
all very large financial institutions are commercial banks, however. Companies with more than
$100 billion in assets include insurers, broker-dealers, investment funds, specialized lenders, and
government-sponsored enterprises (Fannie Mae and Freddie Mac are among the largest firms
overall by assets). Over the long run, large non-banks have emerged, in part because of the
growth in “shadow banking.”12 Shadow banking refers to bank-like activities, such as lending, in
the non-bank financial sector.13 According to one estimate, assets of broker-dealers grew from 3%
of commercial bank assets in 1980 to nearly 30% in 2007. Over the same period, hedge fund
capital increased from less than 1% of bank capital to more than 100%.14 While non-banks have
been engaging in more bank-like activities, banks have also moved into non-banking businesses.
Today, a bank can incorporate as a financial holding company that has depository subsidiaries,
insurance subsidiaries, and broker-dealer subsidiaries, for example.
A few large firms make up a large fraction of revenues in each major segment of the financial
industry. Table 1 shows the 4 largest and 20 largest firms’ respective shares of total industry
revenue for the major industry NAICS (North American Industrial Classification System)
classifications. According to the latest available Census data, securities firms are the most
concentrated when measured by revenue, and the industry grew more concentrated between 1997
and 2007, whether measured by the top 4 or top 20 firms. Credit intermediation, which includes
banking, grew significantly more concentrated between 1997 and 2002, but became slightly less
concentrated between 2002 and 2007. Insurance firms became slightly more concentrated
between 1997 and 2007.
(...continued)
five savings and loan holding companies hold 68% of total assets and the top five state-member banks hold 47% of
total assets; banks in those categories are considerably smaller in absolute terms than bank holding companies,
however.
10 Andrew Haldane and Robert May, “Systemic Risk in Banking Ecosystems,” Nature, vol. 469, January 2011, p. 351.
11 Organization of Economic Cooperation and Development, Bank Competition and Financial Stability, 2011, Figure
1.1.
12 Many of these large institutions that focus on non-banking activities are chartered as bank holding companies or
savings and loan holding companies.
13 For more information, see CRS Report R43345, Shadow Banking: Background and Policy Issues, by Edward V.
Murphy and Tobias Adrian, Adam Ashcraft, and Zoltan Pozsar, “Shadow Banking,” Federal Reserve Bank of New
York, working paper, December 31, 2009.
14 Tobias Adrian, Christopher Burke, and James McAndrews, The Federal Reserve’s Primary Dealer Credit Facility,
Federal Reserve Bank of New York, Current Issues in Economics and Finance, vol. 15, no. 4, New York, NY, August
2009.
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Table 1. Large Financial Firms’ Share of Total Industry Revenue, 1997-2007
(percentage)
Top 4 Firms
Top 20 Firms
1997 2002 2007 1997 2002 2007
Credit Intermediation
12.6 21.5 20.6 33.4 46.4 45.0
(NAICS 522)
Securities (NAICS 523)
19.3
23.6
24.6
47.7
50.0
51.8
Insurance (NAICS 524)
13.7
12.6
14.6
37.9
36.9
40.6
Funds and Trusts
19.0 24.4 n/a 48.9 57.0 n/a
(NAICS 525)
Source: U.S. Census Bureau, Economic Census, various years.
Notes: Data are reported by NAICS code.
It remains to be seen how concentration, as measured by the Census, was affected by the financial
crisis. The financial crisis reduced the number of large financial firms, but also led to an increase
in the size of the remaining large firms, through a series of mergers and acquisitions.15
Compared with other industries, financial firms are large in dollar terms when measured by assets
and liabilities but not by measures such as revenue because of the nature of financial
intermediation. For example, there are only two firms (Berkshire Hathaway and General Electric)
with revenues from financial businesses—and both have substantial non-financial revenues—and
no bank holding companies among the 10 largest Fortune 500 firms in 2013 when measured by
revenue, but financial companies are the only Fortune 500 firms with more than $1 trillion in
assets.16 Financial firms are also not as concentrated as some other industries.17 In layman’s
terms, there is no “Pepsi/Coke” dominance in the financial sector. These comparisons may help to
illustrate why traditional policy tools such as antitrust have not been used against large financial
firms recently and suggest that the TBTF phenomenon in finance lies in the nature of financial
intermediation, which is the topic of the next section.
Economic Effects of Too Big to Fail
Contagion can be transmitted from small or large financial institutions (see the following text
box), but large firms pose unique problems. Firms are likely to have more counterparty exposure
to large firms, and the losses or disruptions caused by counterparty exposure when a large firm
fails could be severe enough to lead to failure of third parties. Problems at large firms could also
lead to “fire sales” in specific securities markets that depress market prices, thereby imposing
15 According to one estimate, mergers and acquisitions during the crisis increased the assets of the four largest banks
from 30% to 44% of total bank assets. Richard Fisher, “Two Areas of Present Concern,” speech before the Senior
Delegates’ Roundtable of the Fixed Income Forum, Federal Reserve Bank of Dallas, July 23, 2009.
16 Data can be accessed at http://money.cnn.com/magazines/fortune/fortune500/. The lack of financial firms in the top
10 by revenue does not appear to be driven by the effects of the financial crisis. For example, there were two
predominantly financial firms in the top 10 by revenue in 2006.
17 One study of the ten most concentrated industries did not include any financial firms. See Andrea Alegria et al,
“Highly Concentrated: Companies that Dominate Their Industries,” IBISWorld, February 2012,
http://www.ibisworld.com/Common/MediaCenter/Highly%20Concentrated%20Industries.pdf.
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losses on other holders of similar securities.18 Some economists argue that the real problem is
some firms are “too interconnected to fail.” That is, it is not the sheer size of certain firms that
causes contagion, but the fact that most activity in certain key market segments flows through
those firms.19 According to the International Monetary Fund (IMF), a few large firms “dominate
key market segments ranging from private securitization and derivatives dealing to triparty repo
and leveraged investor financing.”20 Were the interconnected firm to fail, other firms would have
difficulty absorbing the failed firm’s business, and there would be disruptions to the flow of
credit. If problems in one market segment undermine an interconnected firm, problems can
spread to the other market segments in which the firm operates.
Why Are Financial Firms Vulnerable to Instability?
Economists consider financial firms to be uniquely vulnerable to instability because a fundamental feature of financial
intermediation is the use of short-term liabilities (debt or deposits) to finance long-term assets (e.g., loans). As a
result, assets cannot be liquidated fast enough or at a sufficient price to fund redemptions in a panic. The use of
liabilities, rather than equity, to finance most assets (referred to as “leverage”) can result in losses exceeding equity,
which results in insolvency, or an inability to meet obligations to all creditors in full. These features make financial
intermediaries inherently vulnerable to runs—since those who redeem funds first are thought more likely to access
their funds, there is an incentive for creditors to rush to redeem, whether the firm is suffering from a liquidity
problem or a solvency problem. Panics can be self-fulfilling: whether or not the institution originally had financial
problems, a panic can lead to its failure. Panics are also prone to contagion—the observation of a run at one
institution can lead creditors to run on other institutions, because of perceived connections or similarities to the
original firm.
The classic run involves depositors at banks, but the recent crisis demonstrated that other debt markets can also be
susceptible to runs for banks and non-bank financial firms. Non-bank financial firms were highly reliant on short-term
borrowing, through financial instruments such as repurchase agreements and commercial paper. They favor short-
term borrowing because in normal conditions these short-term funds are inexpensive and readily available. The short
maturity of these instruments meant that loans needed to be rol ed over frequently. The proximate cause of most of
these firms’ failure was the inability to roll over maturing debt. When these firms experienced financial difficulties,
counterparties became reluctant (or were not in a position) to transact and maintain business relationships with
them. For example, major investment banks are “market-makers” (ready buyers and sellers) for securities markets;
provide prime brokerage services for hedge funds; are major participants in over-the-counter markets for securities
such as derivatives; play important roles in payment, clearing, and settlement activities; and so on. If counterparties in
any of these areas are no longer wil ing to transact with the firm because of fears of a run, the firm’s financial
difficulties can quickly compound.
Although some policy makers have dismissed the claim that any firm could be too big to fail,
many analysts believe the failure of Lehman Brothers, occurring in the context of difficulties at
several large financial firms, was the proximate cause of the worsening of the crisis in September
2008.21 One can debate whether policy actions in the months leading up to Lehman Brothers’
18 An alternative perspective is that the simultaneous failure or emergency experienced by many firms during the crisis
was primarily caused by a lack of diversified risk that led to many firms experiencing losses on similar investments (in
this case, mortgage-related investments), as opposed to losses being caused by counterparty exposure. This perspective
does not necessarily require a TBTF problem to explain the crisis. For example, see Daniel Tarullo, “Regulating
Systemic Risk,” speech at 2011 Credit Markets Symposium, Charlotte, North Carolina, March 31, 2011,
http://www.federalreserve.gov/newsevents/speech/tarullo20110331a.htm.
19 Hereafter, for convenience, this report will use the terms “too big to fail” and “too interconnected to fail”
interchangeably.
20 International Monetary Fund, United States—Selected Issues, July 13, 2009, p. 24.
21 See, for example, Financial Crisis Inquiry Commission, Final Report, Ch. 18, http://fcic-static.law.stanford.edu/
cdn_media/fcic-reports/fcic_final_report_full.pdf. For an alternative perspective on the importance of Lehman
Brothers, see “Dissenting Views” in the same report.
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failure made its failure more or less disruptive, but it is fair to say that it is unlikely that the panic
that followed could have been avoided since the nature of the disruptions its failure caused
(notably, its effect on money markets) was not widely foreseen.22 “Bailing out” TBTF firms may
not be an intended policy objective, but may become the second-best crisis containment measure
when the failure of a TBTF firm is imminent to prevent fallout to the broader financial system
and the economy as a whole.
While many people object to rescuing TBTF firms on moral or philosophical grounds, there are
also economic reasons why having firms that are TBTF is inefficient. In general, for market
forces to lead to an efficient allocation of resources, finding a good use of resources must be
financially rewarded and a bad use must be financially punished. Firms generally run into
financial problems when they have persistently allocated capital to inefficient uses. To save such
a firm would be expected to retard efforts to shift that capital to more efficient uses, and may
allow the firm to continue making more bad decisions in the future. The TBTF problem results in
too much financial intermediation taking place at large firms and too little at other firms from the
perspective of economic efficiency, although not necessarily from the perspective of non-
economic policy rationales.23 Because large and small financial firms do not serve exactly the
same customers or operate in exactly the same lines of business, too much capital will flow to the
customers and in the lines of business of large firms and too little to those of small firms in the
presence of TBTF.
Preventing TBTF firms from failing is argued to be necessary for maintaining the stability of the
financial system in the short run. But rescuing TBTF firms is predicted to lead to a less stable
financial system in the long run because of moral hazard that weakens market discipline. Moral
hazard refers to the theory that if TBTF firms expect that failure will be prevented, they have an
incentive to take greater risks than they otherwise would because they are shielded from at least
some negative consequences of those risks.24 In general, riskier investments have a higher rate of
return to compensate for the greater risk of failure. If TBTF firms believe that they will not be
allowed to fail, then private firms capture any additional profits that result from high-risk
activities, while the government bears any extreme losses. Thus, if TBTF firms believe that they
will be rescued, they have an incentive to behave in a way that makes it more likely they will fail.
To see how the moral hazard problem is transmitted, it is helpful to examine who gets directly
“rescued” when the government intervenes to prevent the fallout to the overall financial system
and broader economy. The direct beneficiaries of a rescue will include some combination of the
firm’s management, owners (e.g., shareholders), creditors (including depositors), account holders,
22 For more information on the events of 2008, see the Appendix.
23 In the case of Fannie Mae and Freddie Mac, this was arguably the policy goal—Fannie Mae’s and Freddie Mac’s
low-borrowing costs were seen by some as desirable insofar as it led to lower borrowing costs for homeowners. A key
feature of the housing bubble was overinvestment in housing, spurred by the over-availability of mortgage credit.
24 Evidence that larger banks are consistently riskier than smaller banks is mixed. For example, one measure of
riskiness is leverage (the proportion of liabilities to equity held by a bank). One study found that large U.S. commercial
banks were less leveraged than small banks on average during the past decade, but the median large bank was modestly
more leveraged than the median small bank. Large banks also had more off-balance-sheet activities, which some
believe made banks appear to be less risky than they turned out to be. The study also found that investment banks were
much more leveraged than commercial banks, and large investment banks were more leveraged than small ones.
Source: Sebnem Kalemli-Ozcan, Bent Sorensen, Sevcan Yesiltas, “Leverage Across Firms, Banks, and Countries,”
National Bureau of Economic Research, working paper no. 17354, August 2011. Anecdotal evidence points to a
number of large banks whose risky behavior resulted in failure or rescue during the crisis, but most failing banks over
the past few years were small banks.
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and counterparties. Under bankruptcy, these groups would bear losses to differing degrees
depending on the legal priority of their claims. Government assistance, depending on its terms,
can protect some or all of these groups from losses. In some recent government rescues,
management has been replaced; in others, it has not. Even if management believes that losses will
lead to removal, managers may prefer excessive risk taking (with higher expected profits)
because they are not personally liable for the firms’ losses.25 In some cases, shareholders have
borne some losses through stock dilution, although their losses may have been smaller than they
would have been in a bankruptcy. Creditors, account holders, and counterparties have generally
been shielded from any losses. Thus, government rescues have not mitigated the moral hazard
problem for creditors and counterparties. Because the government will only intervene in the case
of extreme losses, moral hazard may manifest itself primarily in areas affected only by systemic
events (referred to as “tail risk”). For example, extreme losses from counterparty risk may be
ignored by counterparties to TBTF firms if they believe that government will always intervene to
prevent failure; if so, costs (such as the amount of margin a counterparty will require) will be
lower for TBTF firms than competitors in these markets.
Do TBTF Firms Enjoy a Funding Advantage or Implicit Subsidy?
Economic theory predicts that in the presence of moral hazard, creditors and counterparties of
TBTF firms provide credit at an inefficiently low cost. Some studies have provided evidence that
the funding advantage exists, although many of these studies cover time periods that end before
the enactment of the Dodd-Frank Act.26 Identifying a lower funding cost for large banks alone is
not enough to prove a moral hazard effect because lower cost could also be due to other factors,
such as greater liquidity or lower risk (e.g., greater diversity).27 A GAO review of the empirical
literature found that a funding advantage for large firms during the financial crisis had declined
by 2011. Its own econometric analysis found evidence of a funding advantage during the crisis,
but mixed evidence on the existence of a funding advantage in 2012 and 2013—indeed, more
versions of their model found higher funding costs for large banks rather than the expected lower
costs, holding other factors equal.28
Some view the decision by certain credit rating agencies to rate the largest financial firms more
highly because they assume the firms would receive government support as evidence of the
funding advantage, although two of the three major rating agencies have reduced the magnitude
of this “ratings uplift” in recent years.29 (It should be noted that credit ratings do not directly
determine funding costs.)
25 Economists refer to this as a “principal-agent” problem.
26 Studies using empirical evidence to estimate the TBTF funding advantage are reviewed in Financial Crisis Inquiry
Commission, “Governmental Rescues of ‘Too Big To Fail’ Financial Institutions,” Preliminary Staff Report, August
2010, ch. 3, http://fcic-static.law.stanford.edu/cdn_media/fcic-reports/2010-0831-Governmental-Rescues.pdf; Randall
Kroszner, “A Review of Bank Funding Cost Differentials,” University of Chicago, working paper, November 2013,
https://www.stern.nyu.edu/sites/default/files/assets/documents/con_044532.pdf; Thomas Hoenig, Testimony before the
Committee on Financial Services, U.S. House of Representatives, June 26, 2013, Attachment 3,
http://financialservices.house.gov/uploadedfiles/hhrg-113-ba00-wstate-thoenig-20130626.pdf.
27 See Goldman Sachs, “Measuring the TBTF Effect on Bond Pricing,” Global Markets Institute, May 2013.
28 Government Accountability Office, Large Bank Holding Companies – Expectations of Government Support, GAO-
14-621, July 2014, p. 40-55.
29 Government Accountability Office, Large Bank Holding Companies – Expectations of Government Support, GAO-
14-621, July 2014, p. 24 and Financial Stability Oversight Council, Annual Report, 2014, p. 117.
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This funding advantage is sometimes referred to as the TBTF subsidy, although a subsidy
typically implies a government willingness to provide the recipient with a benefit. Note also that a
subsidy typically takes the form of an explicit direct payment, financial support, or guarantee,
whereas in this case, if the funding advantage exists, it would derive from the expectation of
future support that has not been pledged.
Policy Options
Policy Before and During the Crisis
TBTF policy before the crisis could be described as purposeful ambiguity—policy was not
explicit about what would happen in the event that large financial firms become insolvent, or
which firms were considered TBTF.30 (Certain statutory benefits conferred to Fannie Mae and
Freddie Mac came closer to an explicit TBTF status, and markets treated them as such.)
Conventional wisdom before the crisis was that this ambiguity would help contain the moral
hazard problem—if investors and creditors did not know if a firm was TBTF, they would err on
the side of caution and treat it as if it were not TBTF.31 Problems with large firms in the recent
crisis suggest that this approach was not effective.
Theoretically, moral hazard can be mitigated through prudential regulation for safety and
soundness. Generally, the regulatory regime before the crisis was not based on firm size, but
rather on charter type. Depository institutions were regulated for safety and soundness to
minimize the costs of, and the moral hazard that results from, deposit insurance and access to the
Fed’s discount window. Because some non-bank financial firms did not receive analogous
government protection before the crisis, there was not seen to be a moral hazard problem that
justified regulating them for safety and soundness. Pre-crisis safety and soundness regulation did
not explicitly address the additional moral hazard that results from TBTF, in part because TBTF
firms were not explicitly identified.
Before the crisis, large financial firms were subject to Federal Reserve prudential oversight at the
holding company level if they were organized as bank holding companies or financial holding
companies.32 Prudential regulation entailed supervision and examination for safety and
soundness. In 1997, the Fed and the Office of the Comptroller of the Currency (OCC) set up an
internal team to supervise large complex banking organizations.33 Regulation at the holding
30 Financial Crisis Inquiry Commission, “Governmental Rescues of ‘Too Big To Fail’ Financial Institutions,”
Preliminary Staff Report, August 2010, ch. 3, http://fcic-static.law.stanford.edu/cdn_media/fcic-reports/2010-0831-
Governmental-Rescues.pdf.
31 An alternative perspective is that there was no explicit TBTF policy because changes in market structure over time—
namely, the emergence of large, complex banks and non-bank financial firms—did not trigger legislative changes to
create a TBTF policy.
32 Thrifts, credit unions, and banks that did not have holding company structures were not subject to prudential
oversight by the Fed. In this sense, some large banks were regulated differently than some small banks before the crisis,
although not all bank holding companies were large and not all thrifts were small.
33 Since there was no explicit TBTF policy, it is speculative as to whether the Fed considered all of the banks it
identified as large complex banking institutions to be TBTF. Prior to the crisis, there was not authority to set higher
quantitative prudential standards for TBTF banks, although regulators do enjoy discretion in their supervision. See
Federal Reserve, Framework for Risk-Focused Supervision of Large Complex Institutions, Handbook, August 1997,
http://www.federalreserve.gov/boarddocs/srletters/1997/sr9724a1.pdf.
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company level did not mean that all subsidiaries were regulated for safety and soundness by the
Fed. Bank holding companies (BHCs) could operate non-banking subsidiaries, but banking
regulators could only regulate banking subsidiaries for safety and soundness. “Firewalls” were
meant to protect the depository subsidiary from losses at other types of subsidiaries. The holding
company had to demonstrate that it was a source of strength for the depository subsidiary.34
Government-sponsored enterprises, such as Fannie Mae, Freddie Mac, and the Federal Home
Loan Banks, were also subject to prudential regulation by their own regulators. Prudential
regulation did not prevent all large banks or the GSEs from experiencing financial difficulties
during the crisis.
Some of the large firms that experienced financial difficulties in the recent crisis, however, were
not bank holding companies, under Fed regulation, at that time. Types of large firms that were not
BHCs included some government sponsored enterprises, insurance companies, investment banks
(or broker-dealers), and hedge funds. Insurance subsidiaries were regulated for safety and
soundness at the state level. Investment banks complied with an SEC net capital rule. Some large
financial firms, including AIG and Lehman Brothers, were thrift holding companies supervised
by the Office of Thrift Supervision before the crisis. The Office of Thrift Supervision was mainly
concerned with the health of AIG’s and Lehman Brothers’ thrift subsidiaries, although those were
a minor part of their businesses.
Some large financial firms voluntarily became BHCs during the crisis. Specifically, the five
largest investment banks either merged with BHCs (Bear Stearns, Merrill Lynch), became BHCs
(Goldman Sachs, Morgan Stanley), or declared bankruptcy (Lehman Brothers) in 2008.
If a bank is heading toward insolvency, the FDIC normally takes it into receivership and resolves
it. Statutory requirements of least cost resolution of failing depositories by the FDIC may also
help to minimize moral hazard, because bailing out firms (i.e., making creditors whole) is often
more costly than shutting a firm down. But least cost resolution could be waived by the Treasury
Secretary, upon the recommendation of the FDIC and Federal Reserve, if a systemic risk
exception were invoked.35 Market participants may have expected that the systemic risk exception
would be invoked for large firms. The presumption before the crisis was that a failed non-bank
would be subject to the standard corporate bankruptcy process; there was no standing policy of
government involvement in the failure of a non-bank, with the exception of conservatorship
authority for Fannie Mae and Freddie Mac.36
The Federal Reserve was authorized to provide liquidity to banks through collateralized loans at
the discount window, with limitations for banks that are not well capitalized. In previous episodes
of financial turmoil such as 1987 and 1998, the Fed’s decision to flood markets with liquidity had
proven sufficient to restore confidence.37 There was no standing policy to provide liquidity to
non-bank financial firms to guard against runs before the recent crisis. Such a policy did not
34 For more information, see Mark Greenlee, “Historical Review of ‘Umbrella Regulation’ by the Board of Governors
of the Federal Reserve System,” Federal Reserve Bank of Cleveland, working paper 08-07, October 2008.
35 For more information, see “Selected Historical Experience With “Too Big To Fail”
36 For more information on the GSEs, see CRS Report RL34657, Financial Institution Insolvency: Federal Authority
over Fannie Mae, Freddie Mac, and Depository Institutions.
37 As discussed above, due to the nature of financial intermediation, financial firms can never hold enough liquidity to
survive a run. Nevertheless, critics have argued that the Fed’s response to turmoil enabled firms to take on excessive
liquidity risk. This policy is sometimes referred to as the “Greenspan put,” referring to the fact that the Fed’s
willingness to provide liquidity in times of trouble provided firms with a hedge against liquidity risk.
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prove necessary to maintain stability before the recent crisis, perhaps because there was less
historical experience with non-bank runs, and perhaps because non-bank financial firms have
become a more important part of the financial system over time. The Fed had broad existing
emergency authority under Section 13(3) of the Federal Reserve Act to lend to non-banks, but
prior to the crisis had not done so since the 1930s.
Policy during the recent crisis could be described as reactive, developing ad hoc in fits and starts
in reaction to events. Ultimately, banks received federal assistance, and a lack of an explicit safety
net and federal prudential regulation did not prevent some non-banks from receiving federal
assistance as well. In the absence of explicit authority to rescue a TBTF firm, as the crisis
unfolded, the broad standing authority was used: Section 13(3) was used to prevent the failures of
Bear Stearns and AIG. Section 13(3) and the FDIC’s systemic risk authority38 was used to offer
asset guarantees to Bank of America and Citigroup. These authorities were also used to create
broadly based emergency programs. Other programs were created after the crisis began under
authority granted by Congress in 2008. Assistance was given under the Housing and Economic
Recovery Act (HERA; P.L. 110-289) to prevent Fannie Mae and Freddie Mac from becoming
insolvent. In October 2008, Congress passed the Emergency Economic Stabilization Act (EESA;
P.L. 110-343), creating the Troubled Asset Relief Program (TARP), which was used, among other
things, to inject capital into several large financial firms.39 The Fed and FDIC authorities are
permanent; as discussed below, both authorities were modified by the Dodd-Frank Act. The
HERA and EESA authority expired in 2010, although funds continued to be available after
expiration under several outstanding contracts.
Policy Options and the Policy Response After the Crisis
Policy options for TBTF can be categorized as preventive (how to prevent TBTF firms from
either emerging or posing systemic risk) or reactive (how to contain the fallout when a TBTF firm
experiences a crisis). A comprehensive policy is likely to incorporate more than one approach
because different approaches are aimed at different parts of the problem. A policy approach that
would not solve the TBTF problem in isolation could be successful in conjunction with others.
Some policy approaches are complementary—others could counteract each other.
Although there are costs to having large financial firms because of the moral hazard problems,
these costs must be weighed against potential benefits to determine the economically optimal
policy response. These benefits are discussed in the section below entitled “Limiting the Size of
Financial Firms.”
When considering each policy option discussed in this section, an alternative perspective to
consider is that problems at large firms during the crisis—such as overleveraging, a sudden loss
of liquidity, concentrated or undiversified losses, investor uncertainty caused by opacity—were
not TBTF problems per se. If, in fact, they were representative of problems that firms of all sizes
were experiencing, policy should directly treat these problems in a systematic and uniform way
for all firms, and not just for TBTF firms, in this view. In other words, prudential regulation, a
38 12 USC 1823(c). In total, GAO reports that the FDIC’s systemic risk exception was invoked five times during the
crisis. See Government Accountability Office, Federal Deposit Insurance Act:Regulators’ Use of Systemic Risk
Exception, GAO-10-100, April 2010.
39 Information on government assistance provided during the crisis can be found in CRS Report R41073, Government
Interventions in Response to Financial Turmoil, by Baird Webel and Marc Labonte.
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special resolution regime, and policies limiting spillover effects could be applied to all firms
operating in a given area rather than just large firms, so arguments for and against these policy
options do not apply only to their application to large firms. If the causes of systemic risk are not
tied to firm size or interconnectedness, then policies based on differential treatment of TBTF
firms could result in systemic risk migrating to non-TBTF firms rather than being eliminated.
End or Continue “Bailouts”?
Options
“Bailouts” are defined differently by different people. For the purposes of this report, they are
defined as government assistance to a single firm to prevent it from failing (i.e., allow it to meet
all ongoing obligations in full), in contrast to widely available emergency government programs
to provide liquidity to solvent firms. TBTF bailouts could be delivered through assistance unique
to the firm or through existing government programs on a preferential, subsidized basis.40 They
could come in the form of federal loans, insurance, guarantees, capital injections, or other firm-
specific commitments.
Three broad policy approaches to government “bailouts” of failing TBTF firms are available: (1)
institutionalize the availability of assistance in standing programs with standards and procedures
for access enumerated beforehand; (2) offer assistance on an ad hoc basis using broad,
discretionary authority, adding authority as necessary; or (3) eliminate any source of broad
authority that could potentially make assistance available (often referred to as a “market
discipline” policy).
The policy approach pursued before and during the crisis was essentially the second, as discussed
in the previous section. The crisis left many policy makers and observers criticizing this approach
as arbitrary, unfair, lacking in transparency, and too costly (although, in most cases, funds were
eventually repaid in full).41 Many economists would also credit it with eventually restoring
financial stability, however, by restoring healthy and unhealthy financial firms’ access to liquidity
and capital.42
One problem with a “bailouts” approach is that one can only learn whether a firm’s failure would
be disruptive if it is allowed to fail. Once a firm has been rescued, there is no way of knowing
how disruptive its failure would have been. As a result, policy makers may decide to err on the
side of caution and rescue any firm that they believe poses risk of contagion since the short-term
40 A GAO evaluation found that while the largest banks received a majority of the assistance from the Fed’s broadly
based emergency programs in dollar terms, they had the lowest ratio of assistance to total assets, whereas the smallest
banks had the highest ratio. By contrast, the largest banks had the highest ratio of guaranteed debt to assets in the
FDIC’s TGLP and the highest ratio of capital to assets in TARP while participating. Government Accountability
Office, Government Support for Bank Holding Companies, GAO-14-18, November 2013, Table 4, 5, and 6.
41 See, for example, Financial Crisis Inquiry Commission, Final Report, Ch. 18, http://fcic-static.law.stanford.edu/
cdn_media/fcic-reports/fcic_final_report_full.pdf; Congressional Oversight Panel, An Overall Assessment of TARP and
Financial Stability, 112th Cong., 1st sess., March 4, 2011, S.Hrg.112-3. For an overview of government assistance
during the crisis, see CRS Report R43413, Costs of Government Interventions in Response to the Financial Crisis: A
Retrospective, by Baird Webel and Marc Labonte.
42 An alternative perspective is that government intervention worsened the crisis by creating policy uncertainty. See, for
example, John Taylor, “The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong,”
November 2008, working paper, http://www.stanford.edu/~johntayl/FCPR.pdf.
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costs of disruption to financial markets may be high. In this sense, the number of firms that are
politically TBTF, particularly at times of market stress, may be larger than the number that are
economically TBTF (i.e., pose systemic risk).
Under the market discipline approach, policy makers would pledge to provide no federal
assistance to any failing firm going forward. In theory, if creditors believed that a firm would not
receive government support, they would not enable firms to take what they perceived to be
excessive risks, and risky actions would be priced more efficiently.43 Unfortunately,
accomplishing this goal is not as simple as proclaiming a “no bailouts” policy. If the moral hazard
problem is to be avoided, market participants must be convinced that when faced with a failure
that could potentially be highly damaging to the broader economy—and just how damaging
cannot be fully known until after the fact—policy makers will not deviate from the stated policy
and provide bailouts. But current policy makers cannot prevent future policy makers from
offering assistance to a failing TBTF firm. Although it is in the long-term interest of policy
makers to withhold assistance to prevent moral hazard, it is in the short-term interest of policy
makers to provide assistance to prevent systemic risk. This makes it difficult to craft a “market
discipline” policy that is credible to market participants.44 Even if policy makers did intend to
maintain a market discipline policy, as long as creditors disbelieved such a policy would be
maintained in the event of a crisis, the moral hazard problem would remain.
Events in the crisis rewarded size and interconnectedness and arguably made any future “market
discipline” policy approach less credible. As discussed in the Appendix, widespread financial
assistance was provided in 2007-2009 to large institutions, although official policy prior to the
crisis could have been construed as a “no bailouts” policy. Creditors may view the 2007-2009
policy response as the most likely outcome in future systemic risk episodes. According to the
Congressional Oversight Panel, “In light of these events, it is not surprising that markets have
incorporated the notion that ‘too big to fail’ banks are safer than their ‘small enough to fail’
counterparts.”45 An alternative perspective is that market participants may view public
dissatisfaction with the 2007-2009 policy response as making a repeat unlikely.
Although it is impossible to prevent future policy makers from making statutory changes to
current policy, current policy makers can make it more difficult for future policy makers to “bail
out” firms by repealing or limiting the existing standing authority that policy makers used to
provide assistance in the crisis. Enacting new authority is likely to be a higher hurdle than
invoking existing authority. Examples of standing authority include the Fed’s 13(3) emergency
authority and the FDIC’s systemic risk exception to least cost resolution. The advantage to
maintaining broad discretionary emergency authority is that it allows policy makers to react
quickly to unforeseen contingencies, and the authority may be used for other purposes than
bailouts, as defined in this report. If assistance became necessary in a fast-moving crisis, new
authority might take too long to enact. By then, the damage to the economy could be worse. In
other words, eliminating broad authority could still result in a TBTF rescue, but after more
financial disruption had occurred. TARP is an example of authority that was enacted relatively
43 As will be discussed in the section below entitled “Resolving a Large, Interconnected Failing Firm,” the failure could
be resolved by the bankruptcy process or a special receivership regime, similar to how banks are resolved. If the latter
is used, then issues arise as to what government support becomes available to creditors through the receiver.
44 Economists refer to this as a “time inconsistency” problem. See Gary Stern and Ron Feldman, Too Big to Fail,
Brookings Institute Press, Washington, D.C., 2004, ch. 2.
45 Congressional Oversight Panel, March Oversight Report, March 16, 2011, p. 153, http://frwebgate.access.gpo.gov/
cgi-bin/getdoc.cgi?dbname=112_senate_hearings&docid=f:64832.pdf.
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quickly during a crisis; nevertheless, its enactment took weeks, whereas contagion can spread in
days.
If one believes that assistance is inevitable because of short-term incentives, there are two
advantages to institutionalizing the terms of assistance. First, making the terms and conditions
explicit reduces the likelihood that assistance could be provided arbitrarily or on the basis of
favoritism, and provides an opportunity to create a funding mechanism so that funding is not
shifted to the taxpayer. Second, an explicit policy avoids policy uncertainty, which can heighten
systemic risk. Arguably, lack of explicit policy added to the panic after Lehman Brothers failed,
because market participants may have incorrectly based decisions on the expectation that Lehman
Brothers would receive the same type of government assistance that Bear Stearns received.46 A
drawback is that setting forth standards for coping with problems at large firms before the fact
could make the moral hazard problem worse by leaving no ambiguity about which firms will
receive assistance.
A related approach would be to allow TBTF firms to fail, but stop contagion by creating standing
credit facilities ahead of time to aid solvent counterparties. This would reduce moral hazard on
the firm’s part (because its managers would have a greater incentive to avoid failure), but would
not eliminate it because counterparties would have less reason to monitor the firm’s riskiness. An
example of this approach is the decision to let Lehman Brothers fail, then subsequently offer a
blanket guarantee for money market mutual funds (MMFs) to prevent a run triggered by one such
fund’s financial difficulties related to its holdings of Lehman debt.47 As the MMF example
illustrates, sometimes this approach could require assistance to be extended much more broadly
than to just direct counterparties. Further, if standing facilities are too easily accessed, they could
crowd out private inter-firm lending.
The optimal approach to bailouts from an economic perspective is arguably the one that is least
costly to the economy in the short and long run. The cost of TBTF to the economy includes the
direct expenditures by the government and the costs of a less stable financial system due to moral
hazard. It can be argued that a failure to bail out TBTF firms would make the system less stable,
because it would potentially allow systemic risk to spread. Alternatively, if bailouts increase
moral hazard, it can be argued that greater moral hazard causes the system to be less stable by
encouraging TBTF firms to act less prudently. However, even without moral hazard, firms would
sometimes fail, as finance is inherently risky.
The 2008 experience lacks a counterfactual to definitively answer the question of which approach
is least costly in the short run. The crisis worsened after Lehman Brothers was allowed to fail and
ended after TARP and other broadly based emergency programs were created. Ad hoc rescues of
failing TBTF firms had not succeeded in stabilizing financial markets to that point, but it is
unknown whether financial conditions would have eventually normalized had that ad hoc policy
been pursued consistently and continually. There is also no counterfactual as to what would have
happened if there had been a consistent policy of allowing firms to fail in the crisis dating back to
Bear Stearns, but the outcome that policy makers believed would occur if Bear Stearns had not
been rescued is similar to events following the Lehman Brothers bankruptcy.
46 See, for example, John Taylor, “The Financial Crisis and the Policy Responses: An Empirical Analysis of What
Went Wrong,” November 2008, working paper, http://www.stanford.edu/~johntayl/FCPR.pdf.
47 For more information, see the Appendix.
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During the crisis, it appeared that the ultimate cost to the government of TBTF “bailouts” could
run into the hundreds of billions, collectively.48 In hindsight, all of the special assistance to large
financial firms (Bear Stearns, the GSEs, Ally Financial, Chrysler Financial, AIG, Citigroup, and
Bank of America), as well as the broadly based emergency programs that large and small
financial firms accessed, turned out to be cash-flow positive for the government (i.e., income and
principal repayments exceeded outlays).49 Cash-flow measures, however, do not reflect the
economic cost of assistance, which would factor in the rate of return a private investor would
have required to make a similar investment, incorporating risk and the time value of money. On
an economic basis, CBO has estimated that special assistance through TARP to Citigroup, Bank
of America and broadly based programs have generated positive profits for the government, while
the TARP assistance to AIG and the auto finance firms was subsidized.50 Although there were
ultimately no net losses in these cases, these government interventions exposed the government to
large potential losses.
Estimates of the cost to the government of “bailouts” do not include the broader costs of a
systemic disruption to the economy, which would have feedback effects on the federal budget. In
this sense, the question of whether it is more costly to bail out TBTF firms or allow them to fail
cannot be definitively settled. Arguably, it was the government’s interventions following Lehman
Brothers’ collapse that ultimately ended the panic, as measured by standard measures of financial
stress such as the spread between Treasury rates and the London Inter-bank Offering Rate
(LIBOR), which did not begin to fall until legislation creating TARP was enacted.51
Policy Response
Maintaining broad discretionary authority, but attempting to limit its scope to prevent bailing out
insolvent firms could be seen as the approach taken by Title XI of the Dodd-Frank Act. It limits
the Fed to providing emergency assistance only through widely available facilities, requires the
Fed to issue rules and regulations on how such assistance will be provided, and prohibits the Fed
from lending to failing firms. It also created new statutory authority for the FDIC to set up
emergency liquidity programs in the future with restrictions and limitations, including that the
recipient must be solvent, rather than allowing the FDIC to again rely on an open-ended systemic
risk exception. Critics would argue that emergency authority remains broad enough under the
Dodd-Frank Act that regulators would be likely to use it to save TBTF firms in the future. The
Dodd-Frank Act did not institutionalize a broadly based capital injection program similar to
TARP’s Capital Purchase Program, which expired in 2010.
48 For example, CBO expected TARP alone to have a subsidy cost of $190 billion in January 2009. See Congressional
Budget Office, The Budget and Economic Outlook, January 2009, p. 25.
49 CRS Report R43413, Costs of Government Interventions in Response to the Financial Crisis: A Retrospective, by
Baird Webel and Marc Labonte.
50 Congressional Budget Office, Report on the Troubled Asset Relief Program, April 2014. There is no recent estimate
of the economic costs for programs outside of TARP. Economic gains on assistance to AIG outside of TARP partly or
wholly offset economic costs to AIG through TARP.
51 An alternative perspective is that government intervention worsened the crisis by creating policy uncertainty. See, for
example, John Taylor, “The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong,”
November 2008, working paper, http://www.stanford.edu/~johntayl/FCPR.pdf.
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Limiting the Size of Financial Firms
Options
One approach to eliminating TBTF is to alter the characteristics of firms that make them TBTF. If
TBTF is primarily a function of size, policy makers could require TBTF firms to sell businesses,
divest assets, or break up to the point that they are no longer TBTF. Size can be measured in
different ways, and regulators would likely need to use discretion to weigh a number of
measures.52 It is also not obvious at what size a firm becomes a source of systemic risk—should
the line be drawn at, say, $1 trillion, $100 billion, or $50 billion of assets?—and could not be
confirmed until firms failed. A firm could be TBTF because of its overall size or because of its
size or importance in a particular segment of the financial market, suggesting that overall size
alone may not be a sufficient determinant of systemic importance. It is also possible that if all
institutions were smaller because of a size cap, the largest institutions would still be systemically
important, even though their size would not be large by today’s standards. A parallel might be the
decision to rescue Continental Illinois in 1984—it was the seventh-largest bank, but had assets of
only $45 billion at its peak, as geographic restrictions meant that the average size of all banks was
smaller.53
The benefits of reducing the size of firms are that, if successful, it could eliminate the moral
hazard and the need for future “bailouts” stemming from TBTF. Other potential costs and benefits
are more ambiguous. Size restrictions may raise the cost or reduce the quality of financial
products currently provided by TBTF firms to consumers and investors; whether this is good or
bad from an economic perspective depends on the cause. If low costs currently stem primarily
from the TBTF “subsidy,” then economic efficiency would improve if large firms are eliminated
even if costs rose as a result.54 Alternatively, if low costs currently stem primarily from economies
of scale, then economic efficiency would be reduced by size restrictions.55 Beyond cost, large
firms may make markets more liquid and enhance customer convenience (such as a nationwide
physical presence). Large non-financial firms may also have financial needs (such as the
underwriting of securities) that would overwhelm small financial firms.56 Similarly, if the success
of the largest firms comes primarily through their ability to innovate and provide more
sophisticated or superior products, then size restrictions could reduce economic efficiency.57
52 One variation on this approach would be to cap borrowing, so that a firm would face no size limit when financing its
activities through capital, but in effect could not grow past a specified threshold through the use of leverage.
53 Federal Deposit Insurance Corporation, “Continental Illinois and ‘Too Big to Fail’,” History of the Eighties, Ch. 7,
http://www.fdic.gov/bank/historical/history/235_258.pdf. For more information, see the section below on Continental
Illinois in the Appendix.
54 See, for example, Anat R. Admati et al, “Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital
Regulation: Why Bank Equity is Not Expensive,” working paper, March 23, 2011, https://gsbapps.stanford.edu/
researchpapers/library/RP2065R1&86.pdf.
55 The evidence on the existence of economies of scale is reviewed in Inci Otker-Robe et al, “The Too-Important-to
Fail Conundrum,” International Monetary Fund, Staff Discussion Note SGN/11/12, May 2011, available at
http://www.imf.org/external/pubs/ft/sdn/2011/sdn1112.pdf. See also David Wheelock and Paul Wilson, “Do Large
Banks Have Lower Costs? New Estimates of Returns to Scale for U.S. Banks,” Federal Reserve Bank of St. Louis,
Working Paper 2009-054E, May 2011, http://research.stlouisfed.org/wp/2009/2009-054.pdf.
56 According to Hamilton Place Strategies, the largest syndicated loan in 2012 involved underwriting by the four largest
U.S. banks and two foreign banks. See Hamilton Place Strategies, “Banking on Our Future,” HPSinsight, February
2013.
57 These benefits are also discussed in Hamilton Place Strategies, “Banking on Our Future,” HPSinsight, February
2013.
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Alternatively, if success of large firms comes primarily through the ability to extract monopoly
rents, size restrictions could improve economic efficiency.58 While reducing size should reduce
systemic risk, there is mixed evidence on whether large firms are more or less likely to fail than
small firms.59 They could be less likely to fail because of greater diversification or more
sophisticated risk management. Canada’s unique experience in avoiding the recent financial crisis
is attributed by some to its highly concentrated banking system.60
Unless rules to limit the size of financial firms are global, size restrictions could place U.S. firms
at a disadvantage at home and abroad in their competition with foreign financial firms. (Some
types of financial activities can be performed abroad more easily than others, so the relevance of
this factor depends on the activity in question.) If business were to shift to large foreign firms, the
overall level of systemic risk in the financial system (which already involves large international
capital flows) may not decline, or could even increase if prudential regulation in the foreign
firm’s home country were inferior to U.S. regulation.
An alternative to restricting size would be to penalize size through a tax or assessment on assets
or liabilities above a stated threshold. In theory, the tax could be set at the rate that would
neutralize any funding advantage that a bank enjoys because of its TBTF status. Given that it is
uncertain at what size a financial firm becomes TBTF, a tax could be viewed as less harmful than
a cap if set at the wrong threshold and perhaps more easily adjusted over time. Other policy
options that raise funding costs for large firms, such as higher capital requirements, can be
viewed as having a similar effect to a tax.61
If policy makers decided to reduce the size of firms, a phase-in or transition period might be
desirable to avoid significant short-term disruptions to the overall financial system. Likewise,
when designing a policy that applies only to firms above a size threshold, one consideration is
whether to make the threshold graduated to avoid cliff effects. Otherwise, firms might take
actions to remain just below the threshold.
Policy Response
Section 121 of the Dodd-Frank Act allows the Federal Reserve to prevent mergers and
acquisitions, restrict the products a firm is allowed to offer, terminate activities, and sell assets if
the Federal Reserve and at least two-thirds of the Financial Stability Oversight Council believes
that a firm that has more than $50 billion in assets poses a “grave threat to the financial stability
of the United States.” It does not allow the Fed to undertake these actions simply because a firm
is large. Before the crisis, a BHC was limited to holding no more than 10% of national deposits
and 30% of any state’s deposits.
58 Financial Stability Oversight Council, Study and Recommendations Regarding Concentration Limits on Large
Financial Companies, January 2011, http://www.treasury.gov/initiatives/Documents/
Study%20on%20Concentration%20Limits%20on%20Large%20Firms%2001-17-11.pdf.
59 See Thorsten Beck, “Bank Competition and Financial Stability, Friends or Foes?,” in Competition in the Financial
Sector, Bank Indonesia and Banco de Mexico, 2008; Antonio Ruiz-Porras, “Banking competition and financial
fragility: Evidence from panel-data, Estudios Economicos, vol. 23, no. 1, 2008.
60 See Renee Haltom, “Why Was Canada Exempt From the Financial Crisis?, Economic Focus, Fourth Quarter, 2013,
p. 22.
61 See Jeremy Stein, “Regulating Large Financial Institutions,” speech at the International Monetary Fund, April 17,
2013.
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Section 622 of the Dodd-Frank Act prevents mergers or consolidations that would result in a firm
with more than 10% of total liabilities of certain financial firms or, in the case of a bank, 10% of
the total amount of deposits of insured depository institutions in the United States. This limit can
be waived in the case of the acquisition of a failing firm. The limit does not prevent firms from
increasing their market share “organically.” The FSOC has determined that Section 622 will limit
the acquisitions of only the four largest bank holding companies at this time.62 A proposed rule
implementing the limit was released in May 2014.63
The Dodd-Frank Act allowed fees to be assessed on banks with more than $50 billion in assets
and non-banks designated as systemically important. The fees were intended to finance the costs
of supervision and resolution, as well as the budget of the Office of Financial Research, as
opposed to being punitive, however.
Limiting the Scope of Financial Firms
Options
The activities in which bank subsidiaries may engage are restricted by statute, but bank holding
companies may own non-bank subsidiaries.64 The subsidiaries of, and off-balance sheet entities
associated with, the largest BHCs are active participants, to varying degrees, in multiple lines of
business outside of traditional bank lending, including asset-backed securitization, trust services,
insurance, money market mutual funds, and broker-dealers.65 A large firm’s presence throughout
the financial system is one source of its “interconnectedness.”
Imposing a size restriction on firms is relatively straightforward—it requires establishing a
measure of size, identifying the threshold size that makes a firm TBTF, and preventing firms from
exceeding that threshold. Altering firms so that they are not too interconnected to fail is more
complicated because there is less consensus on what characteristics make a firm “too
interconnected.”66 If interconnectedness is taken to mean that the firm is an important participant
in several different segments of financial markets, then policy makers could take what has
popularly been described as the “reinstate Glass-Steagall” approach.67 The essence of this
proposal is to prevent a single financial holding company from operating in multiple lines of
62 Financial Stability Oversight Council, Study and Recommendations Regarding Concentration Limits on Large
Financial Companies, January 2011, p. 8, http://www.treasury.gov/initiatives/Documents/
Study%20on%20Concentration%20Limits%20on%20Large%20Firms%2001-17-11.pdf.
63 It can be accessed at http://federalreserve.gov/newsevents/press/bcreg/20140508a.htm.
64 For more information, see the Appendix.
65 Tobias Adrian and Adam Ashcraft, “Shadow Banking: A Review of the Literature,” Federal Reserve Bank of New
York, Staff Report no. 580, October 2012.
66 The Financial Stability Oversight Council has grappled with coming up with developing metrics for these concepts in
its rulemaking (12 CFR Part 1310, RIN 4030-AA00). Different perspectives on defining the concepts can be found in
the public comments to the rulemaking. See also International Monetary Fund, Bank for International Settlements,
Financial Stability Board, Guidance to Assess the Systemic Importance of Financial Institutions, Markets and
Instruments, report, October 2009, available at http://www.imf.org/external/np/g20/pdf/100109.pdf.
67 Reinstating the Glass-Steagall Act in its entirety would involve many other policy areas as well that have changed
significantly over time. Proponents of reinstating Glass-Steagall are usually understood to be focused on four key
provisions. For more information, see CRS Report R41181, Permissible Securities Activities of Commercial Banks
Under the Glass-Steagall Act (GSA) and the Gramm-Leach-Bliley Act (GLBA), by David H. Carpenter and M. Maureen
Murphy.
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financial business, echoing Glass-Steagall’s separation of banking and investing.68 Reintroducing
the separation of lines of business alone would not necessarily prevent the existence of very large
or interconnected firms within a market segment, however, in which case the TBTF problem
would not be eliminated.
The benefits of reducing the scope of firms are that, if successful, it could reduce the riskiest
activities of large firms and thus the need for future “bailouts” stemming from TBTF. It could
also reduce the complexity of large firms, making it easier for regulators and creditors to monitor
them. Weighed against those benefits would be a number of costs.
First, there may be economies of scope that make the financial system more efficient and
complete if firms are large, diversified, and interconnected. Customers may benefit from the
convenience, sophistication, and savings of “one-stop shopping” and expertise in multiple market
segments.
Second, large firms that operate in multiple lines of business may be better able to reduce risk
through diversification, making them less prone to instability in that sense. Traditional banking is
not inherently safe, so forbidding banks from engaging in other activities is no panacea to avoid
bank failures. Fannie Mae and Freddie Mac are examples of firms that were deemed “too big to
fail” and rescued on those grounds although their business was narrowly focused in the mortgage
market.
Third, reintroducing Glass-Steagall separations of businesses without other changes to the
regulatory system would reinforce a system in which banking is subject to close federal
prudential regulation and other financial firms are not. This system would only mitigate systemic
risk if non-banking activities and institutions could not be a source of systemic risk—the recent
crisis experience casts doubt on that assumption. Further, the growth in “shadow banking” makes
it more difficult to segregate activities and their regulation by charter—financial innovation has
blurred the distinction between different lines of business in finance to the point where the
distinction may not be meaningful. In other words, some activities of non-banks are not
fundamentally different from core banking activities from an economic perspective. Thus, the
activities that banks could undertake would be limited, but it would be difficult to prevent non-
banks from engaging in bank-like activities with the same implications for systemic risk, but less
or no prudential regulation. Similar arguments apply to the potential for activities to migrate
abroad, where “universal banking” is common.
Another policy approach would be to limit or ban TBTF firms’ participation in activities that are
deemed inherently too risky—particularly those likely to generate large losses at times of
financial stress—and not central to the business model of the firm. This approach usually focuses
on banks because of their access to the “federal safety net” (deposit insurance and Fed lending),
and hence justified in terms of limiting risk to taxpayers. For example, many policy makers have
argued that banks should not participate in proprietary trading of private securities with the bank’s
own funds.69 Although all financial activities are risky, some risks can be more easily managed
through techniques such as hedging and supervised by regulators. Whether proprietary trading is
68 Under current law, there are still limits on the types of business activities that banking subsidiaries can undertake, but
non-banking subsidiaries within the same holding company may operate in different lines of financial business.
69 Financial Stability Oversight Council, Study and Recommendations on Prohibitions on Proprietary Trading, January
2011, http://www.treasury.gov/initiatives/Documents/
Volcker%20sec%20%20619%20study%20final%201%2018%2011%20rg.pdf.
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an inherently riskier activity than other banking functions, such as lending, is subject to debate. In
addition to proprietary trading, Thomas Hoenig and Charles Morris have proposed to also ban
banks from acting as broker-dealers and market-makers in securities and derivatives.70
Another variation of this proposal, made by the Vickers Commission in the United Kingdom71
and the Liikanen Group in the European Union,72 is to “ring fence” banking activities from these
other types of activities into legally, financially, and operationally separate entities within a
holding company structure.73 This type of approach can be seen in U.S. policies to move swap
dealer activities outside of the depository subsidiary and into a separately capitalized subsidiary
(referred to as “the swap push out rule”).74 Similarly to proprietary trading, a challenge to this
approach is to differentiate between derivatives activities that regulators want depository
subsidiaries to engage in, such as risk-mitigating hedging, and the targeted activities, such as
swap dealing.
Although proposals limiting scope would apply to both large and small banks, some are likely to
have a greater impact on large firms. For example, Bloomberg Government estimates that over
99% of trading assets and liabilities are held by 25 banks.75
A drawback to limiting permissible activities is that there is unlikely to be any sharp distinction
between the risky activity and similar activities that are central to the firm’s core activities. As a
result, regulators may have to make arbitrary distinctions between which activities fall under the
ban, and firms would have an incentive to skirt the ban by designing transactions that resemble
allowed activities but accomplish the same goals as the banned activity. For example, proprietary
trading (“playing the market” with a firm’s own assets) may be hard to distinguish from market-
making (providing clients with a ready buyer and seller of securities) or hedging (buying and
selling securities such as derivatives to reduce risk), and there may be economies of scale to
market-making that concentrate those activities at large firms.76 Finally, risky activities may still
be a source of systemic risk even if banks or TBTFs are banned from conducting them.
Policy Response
Section 619 of the Dodd-Frank Act, popularly referred to as the “Volcker Rule,” prohibits banks
from engaging in proprietary trading and owning hedge funds and private equity funds in the
United States, and requires additional capital to be held by systemically important non-banks that
70 Thomas Hoenig and Charles Morris, “Restructuring the Banking System to Improve Safety and Soundness,” Federal
Reserve Bank of Kansas City, working paper, December 2012.
71 Independent Commission on Banking, Interim Report, United Kingdom, April 2011.
72 High-level Expert Group on Reforming the Structure of the EU banking Sector Chaired by Erkki Liikanen, Final
Report, European Union, October 2, 2012.
73 In the United States, some have argued that each subsidiary within a holding company should be made legally and
operationally separate. See, for example, Sheila Bair, Bull by the Horns, Simon and Schuster, (New York, NY: 2012),
p. 329; Brad Miller, “Use Stand-Alone Subsidiaries to Break Up Megabanks,” Wall Street Journal, October 21, 2012.
74 The term swaps refers to over-the-counter derivatives. It is statutorily defined in 7 USC 1a(47).
75 Cady North, “Volcker Rule Risk Concentrated in 25 Banks,” Bloomberg Government, October 14, 2011, p. 5.
76 See American Bankers Association, Letter to Alastair Fitzpayne: Information on the FSOC Notice 2010-0002,
November 3, 2010, http://www.aba.com/aba/documents/news/VolckerTrust11410.pdf; SIFMA, Volcker Rule,
http://www.sifma.org/issues/regulatory-reform/volcker-rule/position/.
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engage in proprietary trading or own hedge funds and private equity funds in the United States.77
Insurance companies are excluded from the Volcker Rule. Exemptions from the Volcker Rule
include the purchase and sale of assets for purposes of underwriting, market making, hedging,
and on behalf of clients. Securities issued by federal, state, or local governments and government-
sponsored enterprises (GSEs) are exempted, as are investments in small business investment
companies. A final rule implementing the Volcker Rule was adopted in December 2013, with
conformance required by June 2015.78
Section 716 of the Dodd-Frank Act requires banks to “push out” certain swap dealer activities
into separately capitalized affiliates.79 The stated goal of the provision is to prevent swap dealers
and major swap participants from accessing deposit insurance or the Fed’s discount window. The
rule implementing Section 716 was effective July 2013, with a two-year transition period.80
Regulating TBTF
Options
Another approach to addressing the TBTF problem takes as its starting point that no policy can
prevent TBTF firms from emerging. In this view, the dominant role of a few firms in key
segments of the financial system is unavoidable. Breaking them up or eliminating all spillover
effects is unlikely to be practical or feasible, for reasons discussed elsewhere. If so, regulation
could be used to try to counteract the moral hazard problem and reduce the likelihood of their
failure. Prudential regulation, such as capital requirements, could be set to hold TBTF firms to
higher standards than other financial firms, whether or not those firms are already subject to
prudential regulation.
A framework for prudential regulation is well established in depository banking regulation,
featuring the setting of safety and soundness standards and regulatory supervision to ensure
adherence to those standards. Historically, banks have been subject to a closer and more intense
federal prudential regulatory regime than non-banks because of the systemic risk and moral
hazard problems they posed. Some argue that banks generate unique sources of systemic risk
(such as deposit taking) that have no analogue in other types of financial firms.81 If the recent
crisis leads to the conclusion that TBTF non-bank financial firms can also be sources of systemic
risk and contagion, the same arguments made for regulating banks for systemic risk also apply to
TBTF non-banks, however.82
77 For more information, see CRS Report R41298, The “Volcker Rule”: Proposals to Limit “Speculative” Proprietary
Trading by Banks, by David H. Carpenter and M. Maureen Murphy.
78 Available at http://federalreserve.gov/newsevents/press/bcreg/20131210a.htm.
79 For more information, see CRS Report R41398, The Dodd-Frank Wall Street Reform and Consumer Protection Act:
Title VII, Derivatives, by Rena S. Miller and Kathleen Ann Ruane.
80 Available at http://federalreserve.gov/newsevents/press/bcreg/20130605a.htm.
81 The potential for each type of financial firm to be a source of systemic risk is evaluated in Douglas Elliot,
“Regulating Systemically Important Financial Institutions That Are Not Banks,” Brookings Institution, working paper,
May 9, 2013, available at http://www.brookings.edu/research/papers/2013/05/09-regulating-financial-institutions-
elliott.
82 Whether all non-bank firms or only TBTF ones performing a given financial activity are important sources of
systemic risk is beyond the scope of this report, but if all were, a case could be made that a prudential regulatory regime
should be applied uniformly to all such firms, and not just large ones.
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A “one size fits all” model for regulating firms in different businesses for safety and soundness is
unlikely to be practical, however. Policy makers would also need to decide whether to regulate all
of the activities of holding companies operating across several lines of business for safety and
soundness, or regulate only certain activities that are deemed systemically important, perhaps
with legal and financial “firewalls” that isolate the risks of non-regulated activities to the overall
holding company.
Regulation cannot prevent all failures from occurring—large, regulated depository institutions
failed during the crisis. Nor is a system without any failures necessarily a desirable one, since risk
is inherent in all financial activities. Regulation could aim to prevent large financial firms from
taking greater risks than their smaller counterparts because of moral hazard. If successful, fewer
failures or episodes involving disruptive losses would occur. If effective, monitoring by regulators
might be more economically efficient than monitoring by creditors and counterparties, where a
free rider problem reduces the incentive to monitor. In addition, regulators potentially have
greater access to relevant information on risk than creditors and counterparties if opacity is a
problem with large, complex firms.
This proposal relies on effective regulation by the same regulators who were arguably unable or
unwilling to prevent excessive risk taking before and during the crisis by at least a few of the
firms that they regulated.83 Although regulation is intended to limit risky behavior, regulators may
inadvertently cause greater correlation of losses across firms by encouraging all firms to engage
in similar behavior. Some have argued that large firms are “too complex to regulate,” meaning
regulators are incapable of identifying or understanding the risks inherent in complicated
transactions and corporate structures. For example, the six largest BHCs had more than 1,000
subsidiaries and the two largest had more than 3,000 each in 2012. Further, their complexity has
increased over time—only one BHC had more than 500 subsidiaries in 1990, and the share of
assets held outside of depository subsidiaries has grown over time for the largest BHCs.84 One
response to addressing this complexity is by making the regulatory regime more sophisticated,
but some critics argue that this approach is likely to backfire.85 One challenge for the effective
regulation of non-banks that are TBTF is that regulators have less experience with business lines
other than banking, and thus may initially lack the expertise to regulate them effectively. Others
have argued that large firms are “too big to jail,” meaning regulators cannot take effective
supervisory actions against firms if those actions would undermine the firm’s financial health, and
thus financial stability.86
One way that a regulatory approach could potentially backfire is if a special regulatory regime for
TBTF firms is not strict enough, in which case it would exacerbate the moral hazard problem.
Critics fear that such a regime would be particularly vulnerable to “regulatory capture,” the
phenomenon in which the regulated exercise influence over their regulators to ease the burden of
regulation. If so, a special regulatory regime could wind up exacerbating the moral hazard
83 This is discussed in more detail in the Appendix. See also Arthur Wilmarth, “The Dodd-Frank Act: A Flawed and
Inadequate Response to the Too-Big-To-Fail Problem,” Oregon Law Review, vol. 89, April 6, 2011, p. 951.
84 Dafna Avraham, et al., “Peeling the Onion: A Structural View of U.S. Bank Holding Companies,” Liberty Street
Economics, July 20, 2012, available at http://libertystreeteconomics.newyorkfed.org/2012/07/peeling-the-onion-a-
structural-view-of-us-bank-holding-companies.html#.U-TnELFgi68.
85 See, for example, Thomas Hoenig, “Back to Basics: A Better Alternative to Basel Capital Rules,” Federal Deposit
Insurance Corporation, speech delivered to the American Banker Regulatory Symposium, September 14, 2012.
86 This issue was discussed by the Attorney General at a 2013 hearing. See U.S. Congress, Senate Judiciary Committee,
Oversight of the U.S. Department of Justice, 113th Cong., 1st sess., March 6, 2013.
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problem by, in effect, making TBTF status explicit, signaling to market participants that firms in
the special regime enjoyed a protected status and would not be allowed to fail.87 Instead of
increasing the cost of being TBTF, firms in the special regulatory regime could end up borrowing
at a lower cost than other firms (since, in effect, these firms would enjoy a lower risk of default).
Many would point to the experience with the GSEs, Fannie Mae and Freddie Mac, before
conservatorship as a historical example of how a special regulatory regime could backfire. The
GSEs could borrow at a lower cost than other firms because markets believed that the
government would not let them fail—they enjoyed even lower borrowing costs than firms that
markets might believe were implicitly TBTF but not chartered by the government like the
GSEs.88 Institutional shortcomings, critics argue, led to regulatory capture.89 The GSEs were
subject to their own unique capital requirements, set by statute, under which they were found well
capitalized by their regulator at the time, OFHEO, two months before being taken into
conservatorship.90 Yet compared with depositories, GSEs held little capital, were not well
diversified, and experienced large losses during the crisis. The worst-case scenario of opponents
of a separate regulatory regime for TBTF firms is that such a regime would provide a competitive
advantage that would enable more risk taking than before. An example of this scenario was the
GSEs’ ability to borrow at lower cost than other firms.
Adopting these measures may increase overall costs in the financial system, but in the presence of
TBTF, market costs may otherwise be too low from a societal perspective, since risk-taking is too
high. For example, requiring loans to be backed with more capital may make lending more
expensive and less available, but make the firm less likely to fail. If more capital succeeded in
creating a more stable financial system, then the availability of credit could be less volatile over
time. At least partly offsetting the higher costs of capital for firms designated as systemically
important would be relatively lower costs of capital for other firms.91
Even if a heightened prudential regime worked as planned, it could still partly backfire from a
systemic risk perspective. To the extent that it causes financial intermediation to migrate away
from TBTF firms to firms that are not regulated for safety and soundness, the result could be a
less regulated financial system. Since most large firms are currently already BHCs regulated by
the Fed, but with significant lines of business outside traditional banking, this outcome is a
possibility.
Policy Response
Title I of the Dodd-Frank Act grants the Financial Stability Oversight Council (FSOC) the
authority to identify “systemically important” non-bank financial firms (SIFI) by a two-thirds
vote, which must be supported by the Treasury Secretary. Such a firm would be deemed
87 During the debate of the Dodd-Frank Act, policy makers considered keeping the identities of regulated firms
confidential, but they concluded that this would be impractical.
88 Congressional Budget Office, Measuring the Capital Positions of Fannie Mae and Freddie Mac, June 2006.
89 For an in-depth discussion, see the section in the Appendix entitled “Fannie Mae and Freddie Mac.”
90 Office of Federal Housing Enterprise Oversight, “Fannie Mae and Freddie Mac Capital,” Mortgage Market Note 08-
2, July 17, 2008.
91 Assuming that the overall supply of credit remained constant, raising the cost of capital at TBTF firms would reduce
the amount of credit supplied to those firms, thereby increasing the supply of credit available to other firms. Economic
theory predicts that the greater supply of credit available to other firms would reduce their cost of capital.
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systemically important on the basis of a council determination that “material financial distress at
the [firm] or the nature, scope, size, scale, concentration, interconnectedness, or mix of the
activities of the [firm] could pose a threat to the financial stability of the United States.” Foreign
financial firms operating in the United States could be identified by the council as systemically
important. Firms with consolidated assets of less than $50 billion are exempted. Besides the $50
billion threshold, FSOC stated in its final rule that it would consider designating only firms with
at least $30 billion in gross notional credit default swaps outstanding in which it was the reference
entity, $3.5 billion of derivatives liabilities, $20 billion in debt outstanding, a 15 to 1 leverage
ratio (a capital-asset ratio that is not risk-weighted), or a 10% short-term debt ratio.92
To date, FSOC has designated two insurers (AIG and Prudential) and another non-bank (GE
Capital) as SIFIs.93 One other insurer (MetLife) is reportedly under consideration.94 Some have
argued that insurers are already regulated for safety and soundness at the state level, bank
regulations are not suitable for insurers, and the Fed does not have the specialized expertise to
effectively regulate them. On the other hand, state regulators may not be equipped to regulate
non-insurance subsidiaries or the overall firm for systemic risk. More controversially, the FSOC
has investigated whether any “asset managers” (a diverse group that includes mutual funds, hedge
funds, and private equity funds) are systemically important, but has not made any designations to
date. A study by the Office of Financial Research (OFR) identified several channels through
which asset managers could pose systemic risks, while others have argued that only activities, not
firms, in this industry pose systemic risk. The OFR report identified 10 asset managers each with
more than $1 trillion in assets under management.95
Under Subtitle C of Title I, the Fed is the prudential regulator for firms that the FSOC has
designated as a SIFI and any BHC with total consolidated assets of $50 billion. (The FSOC and
Fed may raise the asset threshold above $50 billion.) There are currently about 30 BHCs with
more than $50 billion in consolidated assets.96 BHCs that participated in the Capital Purchase
Program (part of the Troubled Asset Relief Program) would not be able to change their charter to
avoid this regulatory regime. Foreign banks operating with more than $50 billion in assets in the
United States will be required to set up intermediate bank holding companies that are subject to
the Fed’s enhanced regime. The Fed, with the FSOC’s advice, is required to set safety and
soundness standards that are more stringent than those applicable to other nonbank financial firms
and BHCs that do not pose a systemic risk. At the recommendation of the council or on its own
92 FSOC issued a final rule in April 2012. It can be accessed at http://www.treasury.gov/initiatives/fsoc/rulemaking/
Documents/
Authority%20to%20Require%20Supervision%20and%20Regulation%20of%20Certain%20Nonbank%20Financial%20
Companies.pdf.
93 Financial Stability Oversight Council, “Council Names Two Companies for Consolidated Supervision and Enhanced
Prudential Standards,” press release, July 9, 2013.
94 Danielle Douglas, “Insurer Appeals Regulatory Label, Enters Uncharted Legal Realm,” July 4, 2013, p. A14;
Michael Crittenden and Leslie Scism, “MetLife Moves Closer to Risk Designation,” Wall Street Journal, July 17,
2013, p. C3.
95 See Office of Financial Research, Asset Management and Financial Stability, September 2013,
http://www.treasury.gov/initiatives/ofr/research/Documents/OFR_AMFS_FINAL.pdf; Douglas Elliott, “Systemic Risk
and the Asset Management Industry,” Brookings Institution, May 2014.
96 A current list of top 50 depositories by asset size is available at http://www.ffiec.gov/nicpubweb/nicweb/
Top50Form.aspx. Some of the firms on this list are not bank holding companies. Other types of depositories, such as
savings and loan holding companies, with more than $50 billion in assets are not subject to the final rule, but the Fed
has indicated that it intends to propose rulemaking in the future that apply to them. There are no official data on the
largest financial firms that are not depositories.
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initiative, the Fed may set different standards for different systemically important firms or
categories of firms based on various risk-related factors. Fees are assessed on banks and non-
banks regulated under this regime to finance the costs of supervision, as well as the budget of the
Office of Financial Research.
The final rule implementing Subtitle C was adopted in February 2014, and banks must be in
compliance by January 1, 2015.97 The final rule includes requirements for stress tests, capital
planning, and risk management. The final rule also requires any bank with more than $50 billion
in assets to comply with a 15 to 1 debt to equity limit in the event that the FSOC has determined
that it poses a “grave threat” to financial stability. Exposure limits of 25% of a company’s capital
per single counterparty were included in the proposed rule, but the Fed has indicated that it plans
to finalize them at a later date. Capital and liquidity standards for the largest banks have been set
separately through the Basel III rules, discussed below; enhanced capital requirements have not
been required of all BHCs with $50 billion or more in assets. Other prudential standards may be
applied at the Fed’s discretion.
In conjunction with the Dodd-Frank Act, Basel III, a non-binding international agreement on
bank regulation that the United States is in the process of implementing,98 required that
global systemically important financial institutions (SIFIs) must have higher loss absorbency
capacity to reflect the greater risks that they pose to the financial system. The Committee has
developed a methodology that includes both quantitative indicators and qualitative elements
to identify global systemically important banks (G-SIBs). The additional loss absorbency
requirements are to be met with a progressive Common Equity Tier 1 (CET1) capital
requirement ranging from 1% to 2.5%, depending on a bank’s systemic importance. For
banks facing the highest SIB surcharge, an additional loss absorbency of 1% could be
applied as a disincentive to increase materially their global systemic importance in the
future.99
In addition, Basel III creates a counter-cyclical capital buffer that can be modified over the
business cycle and a supplementary leverage ratio incorporating off-balance sheet assets, both of
which will be applied to only the largest banks (specifically, those subject to the “Advanced
Approaches” Rule). In October 2013, the Fed proposed a rule implementing Basel’s liquidity
coverage ratio, applying it to non-bank SIFIs and banks with $250 billion or more assets or $10
billion or more in on-balance sheet exposure, and a less stringent version of the rule to other non-
bank SIFIs and banks with $50 billion or more in assets. The liquidity coverage ratio would
require firms to hold enough liquid assets to meet cash flow needs during a stress period.100
Since 2011, the Financial Stability Board (FSB), an international forum that coordinates the work
of national financial authorities and international standard setting bodies, has annually designated
G-SIBs, based on the banks’ cross-jurisdictional activity, size, interconnectedness, substitutability,
and complexity.101 The FSB has currently designated 29 banks as G-SIBs. Table 2 lists the eight
97 The rule can be accessed at http://federalreserve.gov/newsevents/press/bcreg/20140218a.htm.
98 Many provisions of the Basel III Accord were adopted in rulemaking in July 2013. The 2013 final rule does not
include the capital surcharge for G-SIBs, which regulators have announced will be proposed at a later date. For more
information, see http://federalreserve.gov/bankinforeg/basel/USImplementation.htm.
99 Bank for International Settlements, Basel III Summary Table, http://www.bis.org/bcbs/basel3/b3summarytable.pdf.
100 The proposed rule can be accessed here: http://www.federalreserve.gov/newsevents/press/bcreg/20131024a.htm.
101 Financial Stability Board, “Policy Measures to Address Systemically Important Financial Institutions,” November 4,
(continued...)
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G-SIBs that are headquartered in the United States, and the capital surcharge under Basel III
recommended by the FSB. In addition, several of the foreign G-SIBs have U.S. subsidiaries. The
identified firms are required to meet resolution planning requirements.102 The FSB has proposed
that firms identified as G-SIBs in 2014 meet the capital surcharge requirements beginning in
2016, fully phasing them in by January 2019. The G20, including the U.S. government, endorsed
the FSB’s non-binding proposal.
Table 2. U.S. Banks Identified as G-SIBs and Capital Surcharge
Recommended by the FSB
(surcharge as a % of risk-weighted assets)
Capital Surcharge as a % of
U.S. Financial Firm
Risk-Weighted Assets
Citigroup 2.5%
JP Morgan Chase
2.5%
Bank of America
1.5%
Bank of New York Mel on
1.5%
Goldman Sachs
1.5%
Morgan Stanley
1.5%
State Street
1.0%
Wel s Fargo
1.0%
Source: Financial Stability Board.
In April 2014, the U.S. bank regulators adopted a joint rule that would require these eight banks
to meet a supplementary leverage ratio of 5% in order to pay all discretionary bonuses and capital
distributions and 6% in order to be considered well capitalized as of 2018.103 The supplementary
leverage ratio includes off-balance sheet exposures.
In addition, the Financial Stability Board has identified nine insurers as “globally systemically
important insurers,” three of whom (AIG, Prudential, and MetLife) are headquartered in the
United States.104 Designated insurers will be required to develop recovery and resolution plans
and hold more capital than other insurers by 2019. The FSB has released a methodology for
identifying global systemically important firms that are not banks or insurers, but has not
(...continued)
2011, http://www.financialstabilityboard.org/publications/r_111104bb.pdf. The identification methodology is described
in Basel Committee on Banking Supervision, “Global Systemically Important Banks: Assessment Methodology,”
Consultative Document, July 2011, http://www.bis.org/publ/bcbs201.pdf.
102 Financial Stability Board, “2013 Update of Global Systemically Important Banks,” November 11, 2013,
http://www.financialstabilityboard.org/publications/r_131111.pdf.
103 The rule applies to all banks with more than $700 billion in assets, and was set at that level to include all banks
designated as G-SIBs. The rule can be viewed at http://federalreserve.gov/newsevents/press/bcreg/20140408a.htm.
104 Financial Stability Board, “Global Systemically Important Insurers and the Policy Measures That Will Apply to
Them,” July 18, 2013, http://www.financialstabilityboard.org/publications/r_130718.pdf. The Financial Stability Board
is an international forum of which the United States is a member. A list of the U.S. firms can be found in the section
below entitled “Regulating TBTF.”
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designated any to date.105 Some Members of Congress have been concerned that the FSB
designation process is superseding the national designation process established by the Dodd-
Frank Act.106
Minimize Spillover Effects
Options
A criticism of regulation before the crisis was that regulators did not focus enough on how a
firm’s failure would affect its counterparties or broader financial conditions, or conversely,
whether a firm could withstand a crisis situation. Another approach holds that if firms are TBTF
because their failure would cause spillover effects that would impair the overall financial system,
then instead of altering the TBTF firm, regulators should try to neutralize spillover effects to the
point where the failure of a firm would not impair the broader financial system. According to this
view, once creditors believed that a firm could now safely be allowed to fail regardless of its size
or interconnectedness, the moral hazard problem associated with TBTF would vanish.
One way spillover effects occur is through counterparty risk (the risk of losses because a
counterparty in a transaction cannot fulfill its obligations). Examples of how counterparty risk can
be reduced include moving transactions to clearinghouses and exchanges, requiring
capital/margins for transactions, requiring risk exposures to be hedged, and placing limits on
exposure to specific counterparties (transactions, debt, equity holdings, etc.).107 Adopting these
measures may increase overall costs in the financial system. For example, counterparty limits
could reduce liquidity and raise costs for transactions that are not standardized enough to be
traded on exchanges. In the presence of TBTF, however, market costs may otherwise be too low
from a society-wide perspective, because firms lack the proper incentives to monitor or price in
counterparty risk.
A drawback to this approach is that spillover effects cannot always be identified beforehand. If
counterparty exposure were transparent, in theory all market participants could hedge themselves
against failure ahead of time and the failure would not have contagion effects, or at least the
government could manage the exposure to prevent contagion. In practice, linkages have proven
complex and opaque, and the sources of contagion have proven hard to predict. For example, in
September 2008, policy makers reasoned that market participants and policy makers had had
several months after the rescue of Bear Stearns to prepare for the failure of Lehman Brothers
(indicators such as credit default swaps had signaled an elevated risk of default for months), so
allowing it to enter bankruptcy should not be disruptive.108 Nevertheless, few anticipated that
Lehman Brothers’ failure would lead to a run on money markets, which proved highly disruptive
to commercial paper markets, causing financing problems for many financial and non-financial
issuers.
105 Financial Stability Board, “Assessment Methodologies for Identifying Non-Bank Non-Insurer Global Systemically
Important Financial Institutions,” January 8, 2014, http://www.financialstabilityboard.org/publications/r_140108.htm.
106 Hon. Jeb Hensarling et al, “Letter to Secretary Lew, Chair White, and Chair Yellen,” May 9, 2014.
107 Gary Stern and Ron Feldman, Too Big to Fail (Washington, DC: Brookings Institution Press), 2004.
108 An alternative view is that Lehman Brothers’ bankruptcy was more disruptive because the rescue of Bear Stearns
led creditors to conclude that other large investment banks would also be rescued.
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Identifying spillover effects is likely to be more difficult if a firm is not already regulated for
safety and soundness. Without a prudential regulator closely monitoring the firm’s activities and
examining its counterparties, it is less likely that policy makers could quickly and accurately
identify who would be exposed to a firm’s failure. Much of the necessary information to make
that judgment is unlikely to be publicly available.
Another problem is that some solutions shift, rather than eliminate, counterparty risk. For
example, moving certain activities onto an exchange or clearinghouse may cause that entity to
become “too interconnected to fail.”
Policy Response
The Federal Reserve’s Regulation F (12 C.F.R., Part 206)—in place before the crisis—limits
counterparty exposure for depository institutions. Title I of the Dodd-Frank Act allows the Fed to
set exposure limits of 25% of a company’s capital per counterparty for firms designated as
systemically important by the Financial Stability Oversight Council.109 To date, a rule
implementing this exposure limit has been proposed but not finalized. To reduce counterparty
risk, Title VII of the Dodd-Frank Act requires certain swaps, particularly those that involve large
financial institutions, to be moved onto clearinghouses or exchanges.110 Title VIII of the Dodd-
Frank Act allows the Financial Stability Oversight Council to identify certain payment, clearing,
and settlement systems and activities as systemically important “financial market utilities,” and
allows the Federal Reserve, Securities and Exchange Commission, or Commodity and Futures
Trading Commission to regulate those systems and activities for enhanced prudential supervision.
It also allows systemically important systems to borrow from the Fed in “unusual or exigent
circumstances.” In 2012, regulators issued a final rule implementing Title VIII and designated
eight financial market utilities as systemically important.111
Resolving a Large, Interconnected Failing Firm
Options
Prior to the financial crisis, failing banks were resolved through the FDIC’s resolution regime,
while certain other financial firms, such as broker-dealers, were resolved through the corporate
bankruptcy system.112 Bankruptcy is a judicial process initiated by creditors in order to recover
debts and other liabilities, while the FDIC’s resolution regime is an administrative process
initiated by the FDIC. Examples of the types of powers that the FDIC can exercise to resolve a
depository include transferring and freezing assets, paying obligations, repudiating contracts, and
obtaining judicial stays.113
109 The Fed has issued a proposed rule to implement these standards, which can be accessed at
http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20111220a1.pdf.
110 For more information, see CRS Report R41398, The Dodd-Frank Wall Street Reform and Consumer Protection Act:
Title VII, Derivatives, by Rena S. Miller and Kathleen Ann Ruane.
111 For more information, see CRS Report R41529, Supervision of U.S. Payment, Clearing, and Settlement Systems:
Designation of Financial Market Utilities (FMUs), by Marc Labonte.
112 For more information, see CRS Report R40530, Insolvency of Systemically Significant Financial Companies
(SSFCs): Bankruptcy vs. Conservatorship/Receivership, by David H. Carpenter.
113 See CRS Report RL34657, Financial Institution Insolvency: Federal Authority over Fannie Mae, Freddie Mac, and
(continued...)
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The FDIC typically resolves failed banks through the “purchase and assumption” method, under
which the bank is closed and some or all of the assets and deposits of the failed bank are sold to
healthy banks.114 If losses are too large to be absorbed by creditors, they are absorbed by the
FDIC’s deposit insurance fund, which is pre-funded through assessments on depositories. The
purchase and assumption method avoids open-ended government assistance and keeps the FDIC
out of the business of running banks, but an unintended consequence is that it encourages greater
concentration, since the only entity capable of absorbing a large failed bank is likely to be an even
larger institution.
One rationale behind a resolution regime for banks is that the need to safeguard federally insured
deposits (which can be withdrawn rapidly) requires a swift resolution and gives the FDIC, which
insures the deposits, priority over other creditors. Prompt corrective action and least cost
resolution requirements are intended to minimize losses to the FDIC. The FDIC may initiate a
resolution before failure has occurred—thereby limiting losses to the FDIC and other creditors—
whereas a bankruptcy process cannot be initiated by creditors until default has occurred.
Another example of a resolution regime is the one applied to Fannie Mae and Freddie Mac. Their
regulator, the Federal Housing Finance Agency (FHFA), assumed control of Fannie Mae and
Freddie Mac in September 2008 when FHFA determined that they were critically
undercapitalized. Since then, Fannie Mae and Freddie Mac have operated under government
conservatorship and received quarterly financial transfers from the Treasury to remain solvent
until 2012.115
Part of what makes some financial firms too big to fail is the nature of the bankruptcy process,
according to some analysts. A firm that dominates important financial market segments cannot be
liquidated without disrupting the availability of credit, it is argued. They argue that the deliberate
pace of the bankruptcy process is not equipped to avoid the runs and contagion inherent in the
failure of a financial firm, and that the effects on systemic risk are not taken into account when
decisions are made in the bankruptcy process. The bankruptcy experience of Lehman Brothers is
viewed as evidence of why the current bankruptcy process cannot be successful for a TBTF firm.
Proponents argue that a resolution regime for all TBTF financial firms, regardless of whether the
firm is a depository, offers an alternative to propping up failing firms with government assistance
(as was the case with Bear Stearns and AIG in 2008) or suffering the systemic consequences of a
protracted and messy bankruptcy (as was the case with Lehman Brothers).116 In principle, a TBTF
resolution regime could include a receivership process (where the government seizes control of
the firm in order to wind it down), a conservatorship process (where the government seizes
control in order to continue operations), or both. The FDIC’s typical treatment of a failed bank is
an example of a receivership process; FHFA’s treatment of Fannie Mae and Freddie Mac since
2008 is an example of the conservatorship process.117 Often, banks in receivership are resolved
(...continued)
Depository Institutions, by David H. Carpenter and M. Maureen Murphy.
114 For more information on purchase and assumption and other resolution methods, see the section below entitled
“Resolution of Banks Before and After the Federal Deposit Insurance Corporation Improvement Act.”
115 For more information, see the section below entitled “Fannie Mae and Freddie Mac.”
116 See, for example, Sheila Bair, “We Must Resolve to End Too Big to Fail,” remarks at the 47th Annual Conference
on Bank Structure and Competition, Federal Reserve Bank of Chicago, May 5, 2011, http://www.fdic.gov/bank/
analytical/quarterly/2011_vol5_2/Article1.pdf.
117 For more information, see CRS Report RS22950, Fannie Mae and Freddie Mac in Conservatorship, by Mark
(continued...)
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through acquisitions by healthy firms. In the case of a large firm, acquisitions would result in the
acquiring firm becoming even larger. Were one of the nation’s very largest firms to fail, it is not
clear what firm would have the capacity to acquire it, in which case some other method of
resolution would be necessary.
Supporting the argument for a special resolution regime, the failures of large depositories during
the crisis that were subject to the FDIC’s resolution regime, such as Wachovia and Washington
Mutual, were less disruptive to the financial system than the failure of Lehman Brothers, even
though Wachovia and Lehman Brothers were sequential (46th and 47th largest, respectively) on
Fortune’s list of the 500 largest companies of 2007.118 (Wells Fargo acquired Wachovia before the
FDIC formally became receiver.) Whether the resolution of a non-bank could be handled as
smoothly as these two banks is an open question.119
Critics argue that a resolution regime, depending on its design, could give policy makers too
much discretionary power, which could result in higher costs to the government and preferential
treatment of favored creditors during the resolution. In other words, it could enable “backdoor
bailouts” that could allow government assistance to be funneled to the firm or its creditors beyond
what would be available in bankruptcy, perpetuating the moral hazard problem.120 The normal
FDIC resolution regime minimizes the potential for these problems through its statutory
requirements of least cost resolution and prompt corrective action. It would be expected that a
resolution regime for TBTF firms, by contrast, would at times be required to subordinate a least
cost principle to systemic risk considerations, which the FDIC regime permits. Therefore, a
resolution could be more costly to the government than the bankruptcy process. (On the other
hand, an administrative resolution process could potentially avoid some of the costs of
bankruptcy, such as some legal fees and runs by creditors that further undermine the firm’s
finances.) Critics also point to the conservatorship of Fannie Mae and Freddie Mac—who have
received government support on an ongoing basis since 2008—as evidence that a resolution
regime could turn out to be too open ended and be used to prop up TBTF firms as ongoing
entities, competing with private sector rivals on an advantageous basis because of direct
government subsidies. The Housing and Economic Recovery Act (P.L. 110-289) required
mandatory receivership for the GSEs if they became insolvent, but quarterly transfers from
Treasury prevented insolvency. As noted above, uncertainty before the fact about which firms are
TBTF may lead policy makers to err on the side of taking more failing firms than necessary into
the special resolution process instead of allowing them to enter bankruptcy.
If policy makers, wary of the turmoil caused by Lehman Brothers’ failure, were unwilling to
pursue the bankruptcy option in the future, opposing a resolution regime may be tantamount to
tacitly accepting future “bailouts,” unless some other policy change is made that future policy
makers view as a workable alternative. As an alternative to a special resolution regime, some
(...continued)
Jickling.
118 For more information, see “Washington Mutual and Wachovia.” The Fortune list can be accessed at
http://money.cnn.com/magazines/fortune/fortune500/2007/full_list/index.html.
119 The FDIC gives a detailed explanation of how the failure of a firm like Lehman Brothers could have been managed
more smoothly under a resolution regime in “The Orderly Liquidation of Lehman Brothers Holdings Under the Dodd-
Frank Act,” FDIC Quarterly, vol. 5, no. 2, 2011, p. 31, http://www.fdic.gov/bank/analytical/quarterly/2011_vol5_2/
lehman.pdf.
120 See, for example, Jeffrey Lacker and John Weinberg, “Now How Large is the Safety Net?” Economic Brief 10-06,
June 2010, http://www.richmondfed.org/publications/research/economic_brief/2010/pdf/eb_10-06.pdf.
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critics call for amending the bankruptcy code to create a special chapter for complex financial
firms to address problems that have been identified, such as a speedier process and the ability to
reorganize.121 To some extent, these concerns are already addressed in the bankruptcy code. For
example, the bankruptcy process already allows qualified financial contracts to be netted out. In
the case of Lehman Brothers, healthy business units were sold to competitors relatively quickly
through the bankruptcy process, and remain in operation today.
Until a TBTF firm fails, it is open to debate whether a special resolution regime could
successfully achieve what it is intended to do—shut down a failing firm without triggering
systemic disruption. One key challenge that has been identified is the resolution of foreign
subsidiaries.122 Given the size of the firms involved and the unanticipated transmission of
systemic risk, it remains to be seen whether the government could impose losses on any creditors
without triggering contagion—or would be willing to try. A receiver would face the same short-
term incentives to limit losses to creditors to limit systemic risk that caused policy makers to
rescue firms in the recent crisis in order to restore stability. If the receiver is guided by those
short-term incentives, the only difference between a resolution regime and a “bailout” might turn
out to be that shareholder equity is wiped out, at presumably relatively little savings to the
government.
Policy Response
In July 2008, Congress passed the Housing and Economic Recovery Act (HERA; P.L. 110-289),
which included provisions creating a new regulator (the Federal Housing Finance Agency or
FHFA) for the housing GSEs (the Federal Home Loan Banks, Fannie Mae, and Freddie Mac).
The FHFA was given augmented powers to resolve the GSEs.123 Under these powers, FHFA can
manage assets, sign contracts, terminate claims, collect obligations, and perform management
functions. In September 2008, Fannie Mae and Freddie Mac entered FHFA conservatorship, upon
which FHFA took control of their operations while maintaining them as ongoing enterprises.124
HERA also gave the Treasury Secretary unlimited authority to lend or invest in the GSEs through
the end of 2009. This authority has been used to cover the GSEs’ losses and prevent insolvency
during conservatorship, and funds from Treasury continued to be transferred until 2012.125 While
existing shareholders saw their equity value plummet at the time of conservatorship, creditors and
other counterparties have continued to be paid in full.
121 See, for example, Kenneth Scott and John Taylor, “How to Let Too Big to Fail Banks Fail,” Wall Street Journal,
May 16, 2013, p. A15; Hoover Institute, Resolution Project publications, available at http://www.hoover.org/
taskforces/economic-policy/resolution-project/publications. For a comparison, see Sabrina Pellerin and John Walter,
“Orderly Liquidation Authority as an Alternative to Bankruptcy,” Federal Reserve Bank of Richmond, Economic
Quarterly, vol. 98, no. 1, First Quarter 2012, p. 1.
122 International Monetary Fund, “Resolution of Cross-Border Banks – A Proposed Framework for Enhanced
Coordination,” June 2010, available at http://www.imf.org/external/np/pp/eng/2010/061110.pdf.
123 For more information, see CRS Report RL34623, Housing and Economic Recovery Act of 2008, coordinated by N.
Eric Weiss.
124 For more information, see CRS Report RL34657, Financial Institution Insolvency: Federal Authority over Fannie
Mae, Freddie Mac, and Depository Institutions, by David H. Carpenter and M. Maureen Murphy. Before HERA,
Fannie Mae’s and Freddie Mac’s regulator had more limited powers of conservatorship and no powers of receivership.
125 HERA required that the GSE be put into receivership if it became insolvent. Transfers from Treasury since 2008 to
maintain solvency have had the effect of avoiding the receivership requirement.
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Title I of the Dodd-Frank Act (P.L. 111-203) requires systemically important firms (SIFIs) and
BHCs with at least $50 billion in consolidated assets to periodically prepare resolution plans, also
called “living wills,” explaining how they could be resolved in a rapid and orderly manner.
Failure to submit a credible resolution plan would trigger regulatory action. Title I also creates
early remediation requirements for non-bank SIFIs that are in financial distress (banks already
had early remediation requirements under existing statute).
Title II of the Dodd-Frank Act creates a resolution regime for financial firms whose failure would
have “serious adverse effects on financial stability.”126 However, subsidiaries that are insurance
companies would be resolved under state law, certain broker-dealers would be resolved by the
Securities Investor Protection Corporation, and insured depository subsidiaries would be resolved
under the FDIC’s traditional resolution regime. The process for taking a firm into resolution has
multiple steps and actors. First, a group of regulators (the group varies depending on the type of
firm, but must always include the approval of two-thirds of the Federal Reserve’s Board of
Governors) must make a written recommendation to the Treasury Secretary that a firm should be
resolved, explaining why bankruptcy would be inappropriate. Second, the Treasury Secretary
must determine that resolution is necessary to avoid a default that would pose systemic risk to the
financial system, and default cannot be prevented through a private sector alternative. Prior
identification by the FSOC could be used as evidence that the firm’s failure poses systemic risk,
but it is not a necessary condition. Third, if the company disputes the Treasury Secretary’s
findings, it has limited rights to appeal in federal court. Finally, the FDIC manages the resolution.
The Dodd-Frank Act provides the FDIC with receivership powers, modeled on its bank
receivership powers, with some differences, such as requirements that the FDIC consult with the
primary regulator. As receiver, the FDIC can manage assets, sign contracts, terminate claims,
collect obligations, and perform management functions. The Dodd-Frank Act sets priorities
among classes of unsecured creditors, with senior executives and directors coming last before
shareholders in order of priority. It requires that similarly situated creditors be treated similarly,
unless doing so would increase the cost to the government. The FDIC is allowed to create bridge
companies, as a way to divide good and bad assets, for a limited period of time to facilitate the
resolution. Unlike FHFA’s resolution regime, the Dodd-Frank regime does not allow for
conservatorship.
The Dodd-Frank Act calls for shareholders and creditors to bear losses and management
“responsible for the condition of the company” to be removed. The FDIC is allowed to use its
funds to provide credit to the firm while in receivership if funding cannot be obtained from
private credit markets. Unlike the resolution regime for banks, there is no least cost resolution
requirement and the regime is not pre-funded (the FDIC may borrow from Treasury to finance it).
Instead, costs that cannot be recouped in the process of resolution must be made up after the fact
through assessments on counterparties (to the extent that their losses were smaller under
receivership than they would have been in a traditional bankruptcy process) and risk-based
assessments on financial firms with assets exceeding $50 billion. Since the rationale for limiting
losses to counterparties is to prevent systemic risk, it is unclear how those counterparties could be
assessed after the fact without also posing some systemic risk. A lack of pre-funding means that a
firm’s resolution will, in effect, be financed by its competitors (i.e., firms with assets exceeding
$50 billion) instead of itself. The FDIC is limited to providing assistance in the resolution up to
126 This finding does not require the firm to have been previously designated as systemically important for Title I’s
purposes of heightened prudential regulation.
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10% of the failed firm’s total consolidated assets in the first 30 days of the resolution; thereafter
the limit becomes 90% of total consolidated assets available for repayment.
The FDIC has stated,
the most promising resolution strategy [under Title II] from our point view will be to place
the parent company into receivership and to pass its assets, principally investments in its
subsidiaries, to a newly created bridge holding company. This will allow subsidiaries that are
equity solvent and contribute to the franchise value of the firm to remain open and avoid the
disruption that would likely accompany their closings ... .
Equity claims of the firm’s shareholders and the claims of the subordinated and unsecured
debt holders will be left behind in the receivership....
Therefore, initially, the bridge holding company will be owned by the receivership. The next
stage in the resolution is to transfer ownership and control of the surviving franchise to
private hands....
The second step will be the conversion of the debt holders’ claims to equity. The old debt
holders of the failed parent will become the owners of the new company....127
This approach has been dubbed “Single Point of Entry,” and the FDIC proposed a rule implementing
it in December 2013.128 A BGOV study argues that Single Point of Entry will only mitigate moral
hazard if the holding company holds sufficient common equity and debt that can absorb losses in
resolution at the parent level; otherwise, investors will anticipate that public funds will be used to
absorb losses.129
Selected Legislation in the 113th Congress
S.Amdt. 689 to the FY2014 budget resolution (S.Con.Res. 8) creates a non-binding budget
reserve fund that allows for future legislation “related to any subsidies or funding advantage
relative to other competitors received by bank holding companies with over $500 billion in total
assets.... ” It was adopted by the Senate on March 22, 2013.
H.Con.Res. 25, as amended and passed by the Senate on October 16, 2013, creates a non-binding
budget reserve fund that allows for future legislation “related to any subsidies or funding
advantage relative to other competitors received by bank holding companies with over $500
billion in total assets.... ”
S. 798, the Terminating Bailouts for Taxpayer Fairness Act, would require a leverage ratio of at
least 8% “equity capital” to “consolidated assets” for any bank or bank holding company with at
least $50 billion of consolidated assets and a capital surcharge of at least 15% for any bank or
bank holding company with at least $500 billion of consolidated assets. For other banks, it calls
127 Martin J. Gruenberg, Acting Chairman of the Federal Deposit Insurance Corporation, Remarks to the Federal
Reserve Bank of Chicago Bank Structure Conference; Chicago, IL, May 10, 2012.
128 It can be accessed here: http://www.gpo.gov/fdsys/pkg/FR-2013-12-18/pdf/2013-30057.pdf. For more information
on the FDIC as receiver under Title II, see http://www.fdic.gov/resauthority/.
129 Christopher Payne and Tony Costello, “Will Orderly Resolution Work?,” BGOV Analysis, May 19, 2014.
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for leverage ratios comparable to leverage ratios in place as of May 1, 2013.130 The leverage ratio
for banks with at least $50 billion in assets and capital surcharge for banks with at least $500
billion in assets would apply to non-bank affiliates and subsidiaries, with the exception of
subsidiaries or affiliates that are functionally regulated by the SEC or state insurance regulators.
The bill would prevent “further implementation” of the Basel III agreement, which modifies
safety and soundness regulation of small and large banks. The new capital requirements would
supersede the ratios used under existing capital requirements that determine whether a bank is
well-capitalized and the enhanced capital requirements in the Dodd-Frank Act for BHCs with at
least $50 billion in assets and non-banks designated as systemically important (SIFIs). The bill
allows, but does not require, regulators to establish risk-based capital requirements for financial
institutions with at least $20 billion in assets if the regulators unanimously agree that the bill’s
other provisions are insufficient to prevent excessive risk concentration. The bill bans financial
assistance to non-bank firms, subsidiaries, and affiliates from the federal government, Treasury’s
Exchange Stabilization Fund, the FDIC, or the Fed (through its discount window or Section 13(3)
emergency powers). It also strikes from Section 806 of the Dodd-Frank Act access for financial
market utilities (FMUs) to Federal Reserve account services, borrowing privileges, and interest
payments. It also strikes the FDIC’s systemic risk exception to least cost resolution under its bank
resolution powers. The bill would modify the Federal Reserve’s Small Bank Holding Company
Policy Statement, which permits bank holding companies with consolidated assets of $500
million or less to acquire debt levels higher than permitted larger bank holding companies, by
making the policy applicable to companies with assets of $5 billion or less. Under Dodd-Frank,
bank holding companies subject to the Small Bank Holding Company Policy Statement are
exempt from Basel III. The bill has other provisions, including exemptions from certain
regulations for small or rural banks.
S. 1282, the 21st Century Glass-Steagall Act, would separate depository institutions from
insurance companies, security entities, swap entities, and investment advisors. This legal
separation includes banks affiliating with, owning, or having board members from such
companies; operating in the same financial holding company; and holding an interest in a
financial subsidiary. It would prohibit depository institutions from engaging in insurance
activities, securities activities (including underwriting; market making; acting as a broker-dealer,
futures commission merchant, investment adviser, or investment company; and making
investments in hedge funds or private equity funds), swap activities (including acting as a swap
dealer and major swap participant), agency transactional services, management consulting and
counseling activities, proprietary trading, or prime brokerage activities. It would require banks to
terminate non-bank affiliations, financial holding companies, and financial subsidiaries within
five years, although federal bank regulators could require early termination or six-month
extensions under certain circumstances. It would allow depository institutions to purchase
securities on behalf of customers and for their own accounts, subject to restrictions. It would
allow depository institutions to purchase swaps only to hedge a documented activity against
specified risks. It would prohibit federal savings associations from investing in investment
companies. The bill would also repeal provisions of the bankruptcy code that allow for qualified
financial contracts, including repos, swaps, and master netting agreements, to avoid a stay or be
liquidated, terminated, or accelerated.
130 The current Tier 1 leverage ratio is 4%. The bill provides a definition of equity and assets that make the quantitative
ratios under the bill not directly comparable to ratios under current law, however.
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S. 100, the Terminating the Expansion of Too Big to Fail Act, would repeal the provisions in the
Dodd-Frank Act granting FSOC authority to designate non-bank SIFIs and Fed authority to
subject them to enhanced prudential regulation, and all references to non-bank SIFIs in the Dodd-
Frank Act. It would also repeal Title VIII of the Dodd-Frank Act, which provides for enhanced
prudential supervision of payment, clearing, and settlement systems designated by FSOC as
systemically important (“financial market utilities”). It has been referred to committee.
H.R. 1450/S. 685, Too Big to Fail, Too Big to Exist Act, would require the Secretary of the
Treasury to produce a list of financial firms it believes are too big to fail, and break up those firms
“so that their failure would no longer cause a catastrophic effect on the United States.... ” It has
been referred to committee.
H.R. 129, Return to Prudent Banking Act, would prohibit affiliations between depositories and
investment banks or securities firms. It has been referred to committee.
H.R. 613, Systemic Risk Mitigation Act, would require BHCs with at least $50 billion in assets to
issue long-term subordinated debt equal to at least 15% of the bank’s assets. If the average daily
closing price of a credit default swap using the subordinated debt as a reference entity exceeds 0.5
percentage points, the Fed would require the BHC to increase its Tier 1 capital. If the closing
price exceeds 0.75 percentage points, the Fed may suspend the BHC’s dividend payments. If the
closing price exceeds 1 percentage point, the company would be placed into receivership under
the Orderly Liquidation Authority. The bill repeals the Fed’s authority to implement enhanced
prudential regulation of banks with $50 billion or more in assets and non-bank SIFIs designated
by FSOC. It also repeals the Volcker Rule ban on proprietary trading and hedge fund sponsorship.
The bill was referred to committee.
H.R. 2266, Subsidy Reserve Act, would require the Fed to estimate the implicit subsidy enjoyed
by BHCs with more than $500 billion in assets and non-banks designated as SIFIs by the FSOC,
and would require those firms to set aside that amount in a “subsidy reserve” account.
H.R. 4060, Systemic Risk Designation Improvement Act, would require FSOC to designate
BHCs as SIFIs through the same process used to designate non-banks as SIFIs beginning one
year after enactment. It would prohibit FSOC from designating any BHC with less than $50
billion in assets. It would repeal the section of the Dodd-Frank Act that subjects all BHCs with
more than $50 billion in assets to enhanced supervision.
H.R. 4881, ordered to be reported by the House Financial Services Committee on June 20, 2014,
would place a one-year moratorium on FSOC designations of non-bank SIFIs upon enactment.
H.R. 5016, the Financial Services and General Government Appropriations Act, contained a
provision introduced by H.Amdt. 1096 that “None of the funds made available by this Act may be
used to (1) designate any nonbank financial company as ‘too big to fail’; (2) designate any
nonbank financial company as a ‘systemically important financial institution’; or (3) make a
determination that material financial distress at a nonbank financial company, or the nature,
scope, size, scale, concentration, interconnectedness, or mix of the activities of such company,
could pose a threat to the financial stability of the United States.” It passed the House on July 16,
2014.
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Representative Dave Camp’s Tax Reform Act of 2014 discussion draft includes an excise tax of
0.035% on bank and non-bank SIFIs levied on the SIFI’s total consolidated assets (as reported to
the Federal Reserve) in excess of $500 billion.131
Conclusion
Contagion stemming from problems at TBTF (or too interconnected to fail) firms is widely
regarded to have been one of the primary sources of systemic risk during the recent financial
crisis. To avoid contagion, a series of ad hoc government interventions were undertaken that
protected creditors and counterparties—in a few cases, also managers and shareholders—of large
and interconnected firms from losses. Economic theory suggests that these interventions
exacerbated the moral hazard implications of TBTF, reducing the incentive for creditors and
counterparties to safeguard against extreme outcomes, and increased the incentive to become
larger and more interconnected going forward. Competing theories blame the lack of regulatory
authority and failed regulation for the role of TBTF in the recent crisis. The failures of both
highly regulated banks and lightly regulated non-banks suggest that neither lack of regulation nor
failed regulation were solely responsible for TBTF.
Policy before the financial crisis could be characterized as an implicit market discipline approach
with ambiguity about which firms policy makers considered to be TBTF and how the imminent
failure of a systemically important firm might be addressed. This ambiguity was defended on the
grounds that it would result in less moral hazard than if TBTF firms were explicitly identified,
since the ambiguity would promote market discipline. As the crisis unfolded, policy quickly
shifted to an implicit government assistance approach where Bear Stearns, Fannie Mae, Freddie
Mac, and AIG received direct government support and several emergency programs were
instituted to ensure that other financial firms remained liquid and solvent. Not every large failing
firm received assistance, however, with Lehman Brothers being the notable exception. Both
before and during the crisis, policy could be characterized as ad hoc because arguably no general
approach or principles were articulated that clearly signaled to firms or investors how a
systemically important firm could expect to be treated in different scenarios. Some believe that
this policy uncertainty made the crisis worse.
The rapid shift from market discipline to government assistance during the crisis undermines the
future credibility of the pre-crisis policy approach. If policy makers wanted to return to a market
discipline approach, making that approach effective would arguably require statutory changes that
bolster policy makers’ credibility by “tying their hands” to make assistance more difficult in the
event of a future TBTF failure. This could be accomplished by eliminating broad, open-ended
authority that was invoked during the last crisis, such as Section 13(3) of the Federal Reserve Act
and the FDIC’s systemic risk exception to least cost resolution. Policy makers cannot be
prevented from enacting future legislation allowing assistance, however, much as TARP was
enacted expeditiously when the crisis worsened in September 2008. If investors do not believe
that market discipline will be maintained because policy makers face short-term incentives to
provide government assistance in times of crisis, then a “no bailouts” promise would not prevent
moral hazard.
131 The discussion draft is posted here: http://waysandmeans.house.gov/uploadedfiles/
statutory_text_tax_reform_act_of_2014_discussion_draft__022614.pdf.
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One view is that the genie cannot be put back in the bottle—market participants now believe that
the government will provide assistance to TBTF firms based on the 2008 experience, in which
case they face little incentive to monitor or respond to excessive risk taking. If so, the policy
options to mitigate moral hazard are to regulate TBTF firms or use government policy to reduce
the systemic risk posed by TBTF firms.
In theory, a special regulatory regime for TBTF firms could set safety and soundness standards at
a strict enough level to neutralize moral hazard effects. The complexity and interconnectedness of
large firms complicates their effective regulation, however. Moreover, a special regulatory regime
for TBTF firms could backfire if regulatory capture occurs. Special regulation makes explicit
which firms are TBTF, removing any ambiguity that might promote market discipline. As market
discipline wanes, the burden on regulators to mitigate moral hazard increases. If regulators are
unwilling or unable to apply regulatory standards that negate the benefits of being TBTF, then
being subject to the special regulatory regime could give TBTF firms a competitive advantage
over their industry rivals. The experience of Fannie Mae and Freddie Mac points to the dangers of
this approach. Those two firms were subject to their own regulatory regime prior to the crisis and
were able to borrow at lower interest rates than other financial firms, presumably because of the
implicit government guarantee of their obligations.
Systemic risk stemming from TBTF can also be mitigated by reducing potential spillover and
contagion effects. Examples of proposals to reduce contagion effects include a special resolution
regime for failing systemically important firms and placing limits on counterparty exposure to
large firms. Events in 2008, however, demonstrate the challenge in eliminating systemic risk
posed by TBTF firms because it is unlikely that policy makers will correctly anticipate all of the
channels of contagion in a crisis. Moreover, in determining whether to use government resources
to limit losses to creditors, the receiver faces the same short-term incentives to spare creditors
from losses that lead to moral hazard. Critics point to the open-ended assistance to Fannie Mae
and Freddie Mac since 2008 as a cautionary tale, although this was through government
conservatorship, rather than receivership.
Some argue for eliminating TBTF directly by reducing the size or scope of the largest firms. It is
uncertain what size limit would eliminate TBTF—given that interconnectedness is a nebulous
concept—and success can only be confirmed by observing what occurs after a firm fails. Weighed
against the benefits of eliminating the TBTF problem, the benefits to the financial system that
would be lost by eliminating large firms are also disputed. In the case of reducing scope, some
large firms would remain, and they would be less diversified against risk. Fannie Mae and
Freddie Mac are examples of large, narrowly focused firms that many nonetheless viewed as
TBTF.
A comprehensive policy is likely to incorporate more than one approach because different
approaches are aimed at different parts of the problem. Some approaches focus on preventive
measures (keeping TBTF firms out of trouble), whereas others are reactive (addressing what to do
in the event of a TBTF failure). Some policy approaches are complementary—others could
undermine each other. A market discipline approach is arguably most likely to succeed if coupled
with size limits—although size limits thwart market-based profit incentives and outcomes.
Policies that involve identification of TBTF firms, such as a special regulatory regime, are less
compatible with a market discipline approach. Efforts to minimize spillover effects could be more
effective if the TBTF firms are regulated for safety and soundness, so that spillover effects can
more easily be identified ahead of time. Policy makers have historically coped with the moral
hazard associated with deposit insurance through a combination of safety and soundness
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regulation, a resolution regime, and limits on spillover effects (e.g., limits on counterparty
exposure). (Market discipline’s role is limited by deposit insurance, but it plays a role with
uninsured depositors and other creditors.) Yet TBTF poses some additional challenges to the bank
regulation model, such as the difficulties of imposing a strict least cost resolution requirement on
a resolution regime and effectively regulating firms with complex and wide-ranging activities.
Each of these policy approaches to coping with TBTF has strengths and weaknesses; there is no
silver-bullet solution to the problem because future policy makers face incentives to deviate from
the approach to avoid crises, please interest groups, increase financial innovation and the
availability of credit, and so on. Judging the relative merits of each policy approach depends in
part on which approach future policy makers can best commit to and effectively carry out.
The Dodd-Frank Act devised a strategy to end TBTF that, to varying degrees, incorporated each
approach discussed in this report. Ultimately, the only definitive test of whether the strategy
succeeds is whether the failure of a large firm can be managed without a “bailout” and whether
large firms stay healthy in a financial downturn—events that may not occur for years or even
decades. Until then, perceptions of whether the TBTF problem still exists may develop (and be
observable in market data), which could subsequently be proven true or false.
Although TBTF was one cause of systemic risk in the recent crisis, it was not the only one. The
Dodd-Frank Act also attempted to address other sources of systemic risk. Although the broader
issue of systemic risk is beyond the scope of this report, some policy options discussed in this
report may be more effective at mitigating systemic risk if applied more broadly than to TBTF
firms exclusively. Otherwise, some sources of systemic risk may migrate to firms not regulated
for safety and soundness, without increasing the stability of the overall financial system. If
systemic risk mainly stems from certain activities, regardless of size, a policy focus on large
institutions could risk creating a false sense of security.
Risk is central to financial activity, so an optimal system is probably not one where large firms
never fail. An optimal system is one in which a large firm can fail without destabilizing the
financial system. The only system that can guarantee that large firms will not cause systemic risk
is one without large firms, but a system without large firms may be less efficient. Other
approaches seek to limit systemic risk to acceptable levels. Creating a more stable financial
system by mitigating the moral hazard associated with TBTF may result in credit becoming more
expensive and less available in the short run, but the availability of credit could be less volatile
over time. Some policy makers would consider a tradeoff of less credit for a more stable financial
system to be a tradeoff worth taking, considering that the recent crisis resulted in the deepest and
longest recession since the Great Depression. Arguably, part of the cause of the crisis was that
credit became too readily available, at least in some sectors (e.g., the housing bubble). At least
partly offsetting the higher costs of capital for firms designated as systemically important would
be relatively lower costs of capital for other firms.
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Appendix. Selected Historical Experience With
“Too Big To Fail”
Before the Recent Crisis
There have always been large financial firms in the United States, but concentration within the
banking sector and non-bank financial sector has increased in recent decades. This growth is a
reflection of both policy changes that made growth easier and market changes that made growth
more profitable. For example, technological change altered the types of financial products that
could be offered and the relative costs of offering them, and investments in information
technology may be subject to economies of scale.
Two important policy changes that allowed financial firms to become larger since the Great
Depression were the erosion of the separation of banking from other financial services (such as
investment banking) and the erosion of prohibitions on interstate banking.
The Glass-Steagall Act forbade commercial banks from underwriting or trading in certain types
of securities and affiliating with a business engaged principally in investment banking. It forbade
investment banks from accepting deposits and forbade the same company from owning a
commercial bank and an investment bank. The Bank Holding Company Act prohibited banks
from affiliating with companies engaging in insurance underwriting and defined the activities
closely related to banking that banks were allowed to engage in.132 Implementation of these
restrictions relied upon regulators’ judgment and interpretation, which evolved over time.
Regulators interpreted which securities commercial banks were eligible to purchase, which
activities fell within the “business of banking,” and how closely affiliated commercial banks
could be with investment banks. From the 1970s on, regulators began to interpret Glass-Steagall
more loosely, and differences between commercial banks and investment banks began to erode.133
The Gramm-Leach-Bliley Act (GLBA) of 1999 repealed the prohibition on affiliations between
commercial banks and investment banks or insurance companies, and created a financial holding
company (FHC) structure to facilitate those affiliations. Within a FHC or BHC, firewalls are
required to prevent financial problems at non-depository subsidiary from affecting a depository
subsidiary. (GLBA kept intact the provisions of Glass-Steagall preventing investment banks from
accepting deposits.) While GLBA made it easier for firms in diverse lines of business to operate
under a holding company structure, it also formalized Federal Reserve supervision and regulation
of complex financial firms. GLBA formalized the Fed’s role as “umbrella regulator” of bank
holding companies and financial holding companies and the Office of Thrift Supervision as
umbrella regulator of thrift holding companies, and allowed the regulators to set consolidated
capital standards at the holding company level. The Fed’s role as umbrella regulator gave it very
limited powers, however, to regulate or examine subsidiaries that already had a functional
regulator, such as investment firms and insurers.134
132 70 Stat. 133.
133 For more information on the erosion of Glass Steagall, see CRS Report R41181, Permissible Securities Activities of
Commercial Banks Under the Glass-Steagall Act (GSA) and the Gramm-Leach-Bliley Act (GLBA), by David H.
Carpenter and M. Maureen Murphy.
134 For more information, see Mark Greenlee, “Historical Review of ‘Umbrella Regulation’ by the Board of Governors
(continued...)
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Traditionally, banks were chartered to operate in one state. Interstate banking by national banks
was allowed with a state’s consent under the McFadden Act of 1927 (P.L. 69-639). The absence
of state consent prevented widespread interstate banking for the next several decades, curbing the
growth in nationwide banks. A series of legislative and regulatory changes led to the spread of
interstate banking in the 1980s and 1990s. The Riegle-Neal Interstate Banking and Branching
Efficiency Act of 1994 (P.L. 103-328) further liberalized interstate banking.135 The Riegle-Neal
Act prevented mergers resulting in a BHC exceeding 10% of national deposits and 30% of a
state’s deposits.
The history of government bailouts on TBTF grounds before 2008 is largely limited to the cases
of a few banks. In cases where government intervention to prevent the failure of non-banks on
TBTF grounds was urged (Long-Term Capital Management), the government ultimately decided
not to intervene financially to save the companies, and the spillover effects were limited. The
Appendix does not review cases where federal assistance was provided on other than systemic
risk grounds. Most of the economic arguments of how financial firms are prone to contagion and
runs do not apply to non-financial firms. Examples include assistance to non-financial firms such
as Lockheed in 1970, Chrysler in 1980, and Chrysler and GM in 2008, where assistance was
justified on the grounds of avoiding negative effects on the region or industry.136
Resolution of Banks Before and After the Federal Deposit Insurance
Corporation Improvement Act
Currently, the two main methods for resolving failed banks are “depositor payoff” (winding down
the bank and paying off depositors) and “purchase and assumption” (selling parts of failed banks,
such as deposits and sound assets, to healthy banks).137 In either method, uninsured depositors
and creditors are compensated according to the priority of their claims to the extent that the
proceeds of the sale or liquidation allow; only insured depositors are guaranteed to be fully
compensated. In practice, it was standard for the acquiring bank to take on the accounts of the
uninsured depositors in the case of a purchase and assumption, resulting in no losses for the
latter.138 According to Stern and Feldman, “Reliance on [purchase and assumption] led the deposit
insurer to cover all depositors. The FDIC covered more than 99 percent of uninsured depositors
from 1985 to 1991, a period in which roughly 1,200 commercial banks failed.”139
(...continued)
of the Federal Reserve System,” Federal Reserve Bank of Cleveland, working paper 08-07, October 2008.
135 For more information, see CRS Report 94-744, The Riegle-Neal Interstate Banking and Branching Efficiency Act of
1994, by M. Maureen Murphy. (This report is out of print, but available by request.)
136 See General Accounting Office, Guidelines for Rescuing Large Failing Firms and Municipalities, GAO Report
GGD-84-34, March 29, 1984; CRS Report R41401, General Motors’ Initial Public Offering: Review of Issues and
Implications for TARP, by Bill Canis, Baird Webel, and Gary Shorter; CRS Report R41940, TARP Assistance for
Chrysler: Restructuring and Repayment Issues, by Baird Webel and Bill Canis.
137 For more information on the resolution process, see CRS Report RL34657, Financial Institution Insolvency:
Federal Authority over Fannie Mae, Freddie Mac, and Depository Institutions, by David H. Carpenter and M. Maureen
Murphy.
138 Federal Deposit Insurance Corporation, Managing The Crisis, Part 1, Chapter 3, August 1998, http://www.fdic.gov/
bank/historical/managing/history1-03.pdf.
139 Gary Stern and Ron Feldman, Too Big to Fail, (Washington, D.C.: Brookings Institution Press), 2004, p. 151.
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In the past, an alternative option for resolving troubled banks was open bank assistance. Under
open bank assistance, the FDIC could make loans to banks that could no longer obtain funding
from the private sector in order to keep banks operating as an ongoing concern as an alternative to
resolving them. Banks receiving open bank assistance were often required by the FDIC to replace
management and dilute shareholders, but creditors and depositors would be unaffected. In 1950,
Congress granted the FDIC the ability to give open bank assistance to troubled banks if the bank’s
“continued existence was determined to be ‘essential’ to providing adequate banking services in
the community,” leaving the determination of “essential” to the FDIC.140 “Essentiality” was
invoked 10 times between 1971 and 1991, the largest example of which was for Continental
Illinois, which is discussed below in detail.141 In 1982, the Garn-St. Germain Act broadened the
FDIC’s ability to provide open bank assistance to include cases where the FDIC determined that
it would cost less than liquidation.
Open bank assistance was not used until the 1970s, and was not used frequently until the Savings
and Loan Crisis in the 1980s. Between 1980 and 1992, it was used for 133 banks, which were
larger on average than banks resolved under the other methods. 70 of the 133 instances were for
banks within two specific bank holding companies, BancTexas and First City Bancorporation of
Texas. While these two were not among the largest banks in the country, the FDIC provided them
with open bank assistance on the grounds that their failure would lead to contagion throughout
Texas banks, which had been weakened by the energy bust.142
Open bank assistance could be used because a bank was deemed TBTF, but it could also be used
for other reasons, including regional difficulties, which were more acute before interstate
banking. Some of the banks to which it was applied were large by state standards, but were not
particularly large at a national level (which few banks were, at the time). Furthermore, prior to
various legislation in the 1980s, the purchase and assumption method was relatively more costly
and often resulted in litigation, making open bank assistance relatively more attractive from
regulators’ perspective. Thus, it is difficult to establish how many of these 133 cases were
motivated by TBTF concerns, or how much this experience had led banks, creditors, and
counterparties to conclude that large banks would not be allowed to fail.
Regulators could also avoid resolving a bank through regulatory forbearance. An example of
regulatory forbearance is allowing banks to temporarily operate with capital below required
levels. Regulators could choose to allow regulatory forbearance on TBTF grounds, although in
practice, it often occurred with small thrifts in the 1980s.143
Many economists criticized the handling of bank resolutions in the 1980s, arguing that regulatory
forbearance worsened the moral hazard problem, because a troubled bank allowed to remain in
operation had even more incentive to take risks. Legislation in 1991 reduced the potential for
regulatory forbearance by requiring prompt corrective action and least cost resolution of troubled
140 Federal Deposit Insurance Corporation, Managing The Crisis, Part 1, Chapter 5, August 1998, p. 153,
http://www.fdic.gov/bank/historical/managing/history1-05.pdf.
141 Federal Deposit Insurance Corporation, “Continental Illinois and ‘Too Big to Fail’,” History of the Eighties, Ch. 7,
http://www.fdic.gov/bank/historical/history/235_258.pdf.
142 Besides FDIC resolutions, there were a large number of thrift resolutions in the 1980s. Since these institutions
tended to be small, this experience is not central to the TBTF issue.
143 FDIC, “The Savings and Loan Crisis and Its Relationship to Banking,” History of the Eighties – Lessons for the
Future, December 1997, Ch. 4, http://www.fdic.gov/bank/historical/history/.
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banks.144 These legislative changes and others made open bank assistance less likely, and
according to FDIC data, open bank assistance was not used between 1993 and 2008.145 (Purchase
and assumption continued to be the main method of resolution after 1991, but bids involving only
insured deposits became more common.) Current law, as amended by the 1991 legislation, allows
the FDIC to waive the least cost resolution method if the Treasury Secretary (in consultation with
the President, Federal Reserve, and FDIC) believes that least cost resolution would cause
systemic risk, however.146 TBTF is potential grounds for invoking this systemic risk exception.
Thus, while the 1991 legislation is perceived to have reduced moral hazard at small banks, it is
not clear whether it had a significant effect on the TBTF problem.
Penn Central Railroad
After unsuccessfully seeking financial assistance from Congress and the Fed, Penn Central
Railroad filed for bankruptcy in June 1970. At that time, it had $82 million in commercial paper
outstanding, and when it filed for bankruptcy, the Fed feared its bankruptcy would cause
disruption in the commercial paper market for all borrowers. The Fed temporarily removed legal
interest rate ceilings to avoid a credit crunch and “made clear that the Federal Reserve discount
window would be available to assist banks in meeting the needs of businesses unable to roll over
maturing commercial paper.”147 In other words, the Fed was willing to assist the counterparties to
prevent contagion from a perceived TBTF failure, rather than preventing the firm from failing. In
any case, the perceived contagion from that source did not materialize—data do not indicate an
unusual amount of discount window lending by the Fed in 1970.148
Beginning in 1974, the federal government provided financial assistance to maintain the viability
of passenger rail service in the wake of Penn Central’s bankruptcy. This assistance was not
provided to prevent bankruptcy or to maintain financial stability, and is therefore beyond the
scope of this report.
Franklin National
Franklin National, the nation’s 20th-largest bank, experienced financial difficulties in 1974.
Fearing that its failure would destabilize money markets, the Fed purchased its foreign exchange
balances and futures contracts and provided it loans through the discount window to keep it
afloat. When Franklin was resolved later that year, the FDIC assumed Franklin’s $1.7 billion
unpaid discount window loan.149
144 The Federal Deposit Insurance Corporation Improvement Act, P.L. 102-242. Previously, the FDIC had to
demonstrate that its resolution method was less costly than an insured deposit payoff; that requirement could be waived
in the case of the “essentiality” exception noted above.
145 FDIC data on bank failures can be accessed at http://www2.fdic.gov/hsob/SelectRpt.asp?EntryTyp=30.
146 12 U.S.C 1823(c).
147 Federal Reserve annual report quoted in Anna Schwartz, “The Misuse of the Fed’s Discount Window,” Federal
Reserve Bank of St. Louis Review, September/October 1992, p. 58.
148 For more information on the Fed’s response to the Penn Central failure, see Mark Carlson and David Wheelock,
“The Lender of Last Resort: Lessons from the Fed’s First 100 Years,” Federal Reserve Bank of St. Louis, working
paper 2012-056B, February 2013.
149 Mark Carlson and David Wheelock, “The Lender of Last Resort: Lessons from the Fed’s First 100 Years,” Federal
Reserve Bank of St. Louis, Working Paper 2012-056B, February 2013.
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Continental Illinois
Continental Illinois was the nation’s seventh-largest bank in 1984.150 Continental Illinois losses
have been tied to its aggressive growth in commercial lending beginning in the late 1970s.151
Continental Illinois’ problems began in 1982 with the failure of a correspondent bank, and came
to a head in 1984 with a run by some uninsured depositors. Despite being subject to the FDIC’s
resolution regime, the Comptroller of the Currency at the time testified that Continental Illinois
could not be allowed to fail because it would have caused the failure of more than 100 banks with
deposits at Continental Illinois, and dozens of corporate customers.152 It began receiving federal
assistance in 1984 in the form of discount window loans from the Fed that peaked at $8 billion
and a guarantee by the FDIC of all uninsured depositors and creditors. Eventually, policy makers
decided a more permanent solution was needed. Instead of taking Continental Illinois into
receivership, the FDIC purchased $3.5 billion of problem loans and $1 billion of preferred shares,
and repaid $3.5 billion in loans from the Federal Reserve. The final cost to FDIC was $1.1
billion.153 The chairman of the board and chief executive officer were replaced, and the FDIC
received an option to acquire Continental Illinois’ stock to cover potential losses.
Continental Illinois was regulated for safety and soundness, operating in an era before many
financial regulations were liberalized by the Gramm-Leach-Bliley Act and other legislative and
regulatory changes.154 One problem identified was the pace with which regulators addressed
Continental’s problems—the bank failed in September; the previous May, OCC had stated that
the bank’s capital ratios “compared favorably to those of other multinational banks.”155 Had
regulators addressed Continental Illinois’ financial problems sooner, the ultimate cost to taxpayers
may have been lower. Continental Illinois also led to a more explicit TBTF policy, at least for
banks. At a congressional hearing, Comptroller of the Currency Todd Conover testified that “the
federal government won’t currently allow any of the nation’s 11 largest banks to fail,” but did not
name those banks.156 One study found that after this testimony, the 11 largest banks received
higher ratings on their bonds and borrowed at lower costs.157
Long-Term Capital Management
In 1998, the hedge fund Long-Term Capital Management (LTCM) experienced a liquidity crisis
as a result of large leveraged trading losses resulting from an unanticipated widening of credit
150 Federal Deposit Insurance Corporation, “Continental Illinois National Bank and Trust Company,” Managing The
Crisis, Part 2, Chapter 4, August 1998, http://www.fdic.gov/bank/historical/managing/history2-04.pdf.
151 Federal Deposit Insurance Corporation, “Continental Illinois and ‘Too Big to Fail’,” History of the Eighties, ch. 7,
http://www.fdic.gov/bank/historical/history/235_258.pdf.
152 The claim that more than 100 banks would have failed has been disputed in Larry Wall, “Too Big to Fail After
FDICIA,” Federal Reserve Bank of Atlanta Economic Review, no. 78, January/February 1993, p. 1.
153 Federal Deposit Insurance Corporation, “Continental Illinois National Bank and Trust Company,” Managing The
Crisis, Part 2, Chapter 4, August 1998, http://www.fdic.gov/bank/historical/managing/history2-04.pdf.
154 The role of regulatory supervision in Continental Illinois’ failure is discussed in Federal Deposit Insurance
Corporation, “Continental Illinois and ‘Too Big to Fail’,” History of the Eighties, Ch. 7, http://www.fdic.gov/bank/
historical/history/235_258.pdf.
155 Office of the Comptroller of the Currency, “Statement on Continental Illinois,” news release 84-45, May 10, 1984.
156 Tim Carrington, “U.S. Won’t Let 11 Biggest Banks in Nation Fail,” Wall Street Journal, September 20, 1984, p. 1.
157 Donald Morgan and Kevin Stiroh, Too Big to Fail After All These Years, Federal Reserve Bank of New York, Staff
Report Number 220, New York, NY, September 2005.
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spreads. To avoid a failure that the Fed thought could be destabilizing to the financial system as a
whole, the New York Fed organized a group of large financial institutions to offer LTCM private
assistance in the form of a $3.6 billion capital injection, without the use of any public funds or
guarantees. The Fed was concerned that liquidating LTCM’s large trading positions could
destabilize financial markets and impose large losses on counterparties. In the weeks before the
capital injection, LTCM’s capital had been rapidly depleted by losses, but its net asset value was
still positive, albeit small, at the time of the intervention.158 The Fed’s actions in this case could be
described as helping the rescuing firms (who were also LTCM counterparties) to overcome the
collective action problem—the firms involved were better off recapitalizing the firm than
liquidating it, but unless they could act collectively, it was in no firm’s individual interest to
recapitalize it alone. Critics claimed the Fed’s intervention was unnecessary, as an alternative
offer from another group of investors to purchase the firm on less attractive terms was also
made.159
As in 2007, overall markets came under unusual stress and became illiquid in 1998. Unlike 2007,
the stress passed and markets recovered quickly in 1998. Although it is unknown what would
have happened had LTCM been allowed to fail, this experience seemed at the time to provide a
framework for coping with problems at a TBTF firm—preventing LTCM’s failure prevented
contagion from spreading to other institutions or markets, and conditions were able to quickly
normalize. Since the government did not offer financial assistance, it could continue to claim that
TBTF firms would not be bailed out. LTCM’s problems did not cause investors to doubt the
health of similar firms, as happened in the recent crisis. A lesson that many drew from this
episode was that market mechanisms and existing policy tools could contain the contagion effects
resulting from liquidity problems at a highly leveraged and interconnected firm that was not
regulated for safety and soundness.
Firms in 2008
Several large firms experienced difficulty in 2008, and these problems were resolved in a number
of ways. Bear Stearns and AIG were rescued from failure through government assistance.
Lehman Brothers filed for bankruptcy. Fannie Mae and Freddie Mac entered government
conservatorship. Wachovia and Washington Mutual were acquired by other banks without
government assistance.
As the name implies, “too big to fail” requires both size and the prospect of failure. Part of the
reason the policy issue came to the forefront in 2008 and not earlier is because the crisis led to so
many failures of large and small firms. The probability of a large (or small) firm failing in 2008
was much higher than in the decades of financial stability leading up to 2008. More contentious is
the argument made by some that the probability of failure was also higher in 2008 because large
firms were taking greater risks than in previous decades. Evidence presented in support of this
argument includes the rise over time in financial firms’ use of leverage (debt-to-equity ratios),160
158 For more details, see U.S. General Accounting Office, Long-Term Capital Management, GGD-00-3, October 1999,
http://www.gao.gov/archive/2000/gg00003.pdf.
159 Kevin Dowd, Too Big to Fail? Long-Term Capital Management and the Federal Reserve, Cato Institute, Briefing
Paper Number 52, Washington, DC, September 1999, http://www.cato.org/pubs/briefs/bp52.pdf.
160 The increase in leverage was more pronounced at investment banks than commercial banks. See, for example
Sebnem Kalemli-Ozcan, Bent Sorensen, Sevcan Yesiltas, “Leverage Across Firms, Banks, and Countries,” working
paper, August 2011.
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unstable sources of liquidity, and complex financial instruments such as credit default swaps
(which could be used by a firm to reduce or increase certain forms of risk).
Bear Stearns
In the recent crisis, the investment bank Bear Stearns was the first TBTF firm to receive
government assistance to avert failure.161 Bear Stearns was not a bank holding company regulated
for safety and soundness, nor subject to the FDIC’s resolution regime.162 It came under severe
liquidity pressures in early March 2008, when creditors refused to roll over short-term debt and
counterparties withdrew funds, in what observers have coined a non-bank run. An SEC press
release a few days before its takeover indicated that Bear Stearns had $17 billion of cash and
other liquid assets—an amount that was quickly depleted by the run.163 The run was set off by
concerns that Bear Stearns held a large portfolio of illiquid, “troubled” assets that investors
believed would continue losing value in the future and deplete its remaining capital.
By the weekend of March 15, it had become clear that Bear Stearns could not survive the run by
creditors. Although Bear Stearns was not indisputably “too big to fail” (it was the 138th-largest
firm by revenues in 2007 on Fortune Magazine’s Fortune 500 list),164 some policy makers argued
for government intervention on the grounds that Bear Stearns was “too interconnected to fail,”
meaning too many counterparties and markets would be disrupted by a traditional bankruptcy
filing.165 The Fed sought a healthy firm to acquire Bear Stearns, but was unable to find a willing
partner without financial assistance. Over the weekend of March 15, the Fed arranged and
assisted in the takeover of Bear Stearns by J.P. Morgan Chase at a very low purchase price
(originally $2 per share, subsequently increased to $10 per share), which Bear Stearns’ board of
directors agreed to accept instead of pursuing a bankruptcy filing. The takeover led to
replacement of some of Bear Stearns’ management and the low share price meant that
shareholders were effectively diluted, although they likely fared better than they would have in a
bankruptcy proceeding. J.P. Morgan Chase agreed to honor all of Bear Stearns’ contractual
obligations, however, which meant that creditors and counterparties were fully compensated,
creating moral hazard problems.
The main stumbling block for J.P. Morgan Chase was Bear Stearns’ large portfolio of troubled
assets. As part of the agreement, the Fed agreed to purchase up to $30 billion of Bear Stearns’
assets through Maiden Lane I, a new Limited Liability Corporation (LLC) based in Delaware that
it created and controlled. J.P. Morgan Chase would bear up to $1.15 billion in future first losses,
based on assets valued at $29.97 billion at marked-to-market prices by Bear Stearns on March 14,
2008.166 About half of these assets were collateralized mortgage obligations. The Fed has
161 For more detailed information, see CRS Report RL34427, Financial Turmoil: Federal Reserve Policy Responses, by
Marc Labonte.
162 Bear Stearns complied with an SEC net capital rule, but was not subject to safety and soundness supervision. For
more information, see CRS Report R43087, Who Regulates Whom and How? An Overview of U.S. Financial
Regulatory Policy for Banking and Securities Markets, by Edward V. Murphy.
163 Securities and Exchange Commission, “Statement of SEC Division of Trading and Markets Regarding The Bear
Stearns Companies,” press release 2008-44, March 11, 2008, http://www.sec.gov/news/press/2008/2008-44.htm.
164 List can be accessed at http://money.cnn.com/magazines/fortune/fortune500/2007/full_list/index.html.
165 Greg Ip, “Central Bank Offers Loans to Brokers, Cuts Key Rate,” Wall Street Journal, March 17, 2008, p. A1.
166 Federal Reserve Bank of New York, “New York Fed Completes Financing Arrangement Related to JPMorgan
Chase’s Acquisition of Bear Stearns,” press release, June 26, 2008.
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gradually sold off the assets, in order “to minimize disruption to financial markets and maximize
recovery value.”167 This transaction exposed the Fed to significant credit risk on its balance sheet
for the first time in decades. By 2012, Maiden Lane had received more from asset sales than the
Fed had contributed to their purchases. Principal and interest were recouped, and some assets
remained that could provide the Fed with additional future profits when sold. CBO estimated at
the time of inception that the Maiden Lane transaction was not subsidized since the assets were
bought at market prices.168 In addition, during the JP Morgan Chase takeover, Bear Stearns had an
average of $13.9 billion loans outstanding from the Primary Dealer Credit Facility from March 17
to June 23, 2008, and $1.5 billion loans outstanding from the Term Securities Lending Facility
from March 28 to May 9, 2008.169 These facilities were broadly based emergency Fed programs
created during the crisis. These loans were repaid in full with interest.
Had Bear Stearns been a bank holding company, it might have been able to boost its liquidity
with collateralized loans from the Fed. It also would have been subject to prudential regulation by
the Fed that might have required it to pursue a more conservative business strategy. Since it was
not a bank holding company, the Fed relied on emergency lending powers not used to lend to
non-banks since the Great Depression. Since these powers limited the Fed to lending, the Fed was
required to set up the LLC structure to make the asset purchases possible.
Although Bear Stearns’ liquidity problems were driving it into bankruptcy had the government
not interceded, it is unclear whether it was insolvent. Before that weekend, Bear Stearns was not
insolvent by two common measurements: its stock price (representing the current market
valuation of the firm’s net worth) was still $30 per share, and its primary regulator, the Securities
and Exchange Commission (SEC), issued a press release on March 11 that stated that Bear
Stearns was adequately capitalized according to its net capital rule.170 Even after the crisis,
existing shares were valued positively in the J.P. Morgan Chase takeover, and no capital was
provided to Bear Stearns as part of the Fed’s assistance (since the assets bought by Maiden Lane
were purchased at market value, according to the Fed). On the other hand, J.P. Morgan stated that
the equity in Bear Stearns was exhausted and J.P. Morgan Chase took additional losses from costs
associated with the Bear Stearns acquisition.171
Unlike the LTCM experience, the rescue of Bear Stearns arguably did not cause investors to
conclude that Bear Stearns was an isolated “bad apple.” Instead, speculation persisted over the
next few months that other investment banks would suffer the same fate—speculation that came
to a head with the wave of financial firm failures in September 2008.
167 Federal Reserve Bank of New York, “Statement on Financing Arrangement of JPMorgan Chase’s Acquisition of
Bear Stearns,” press release, March 24, 2008.
168 Congressional Budget Office, The Budgetary Impact and Subsidy Costs of the Federal Reserve’s Actions During the
Financial Crisis, May 2010.
169 Lending records can be accessed at http://www.federalreserve.gov/newsevents/reform_pdcf.htm.
170 Securities and Exchange Commission, “Statement of SEC Division of Trading and Markets Regarding The Bear
Stearns Companies,” press release 2008-44, March 11, 2008, http://www.sec.gov/news/press/2008/2008-44.htm.
171 J.P. Morgan Chase, Annual Report, 2008, p. 9, http://files.shareholder.com/downloads/ONE/
2506919982x0x283416/66cc70ba-5410-43c4-b20b-181974bc6be6/2008_AR_Complete_AR.pdf.
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Ban on Naked Short Selling in July 2008
As financial turmoil worsened in the summer of 2008, the stock value of many large financial
firms fell quickly. The SEC responded on July 15, 2008, by announcing that investors would no
longer be able to “naked short sell” the stocks of 19 large financial firms, an investment strategy
that would pay off if the firms’ stock price fell further.172 The firms chosen were Fannie Mae,
Freddie Mac, and the primary dealers (large financial firms that conduct open market operations
with the Federal Reserve).173 Some market participants perceived this announcement as an
explicit list of the firms that the government considered too big to fail. If this announcement was
intended to rescue troubled firms, either by making short selling more difficult or by making too
big to fail status more explicit, it did not work in all cases—in September 2008, Lehman Brothers
entered bankruptcy, while Fannie Mae and Freddie Mac entered government conservatorship. Nor
did the list closely correspond to which firms would or would not receive government assistance
subsequently—American International Group (AIG) received assistance although it was not one
of the 19 firms listed, while Lehman Brothers did not receive although it was included on the list.
The July ban was superseded by an SEC rule issued on September 18, 2008, that temporarily
banned all short-selling of the stocks of 700 financial firms and an October 1, 2008, rule that
imposed a permanent ban on naked short-selling.
Fannie Mae and Freddie Mac
Not only were Fannie Mae and Freddie Mac very large, their TBTF status was also influenced by
their unusual status as government sponsored enterprises (GSEs). Because of unusual features
such as their congressional charter, line of credit with the Treasury, dominance of the home
mortgage secondary market, and original status as government agencies, investors perceived them
as more likely to be backed by the government than other firms, although their securities had no
explicit government guarantee. This perception allowed them to consistently borrow at a lower
cost than other financial firms, despite holding relatively little capital. Before conservatorship,
Fannie Mae and Freddie Mac were the only firms regulated by their federal regulator, whose
independence and powers were limited compared to other regulators.174 These institutional
features led critics to argue that the GSEs enjoyed the benefits of “regulatory capture.” Their
regulator found them to meet the statutory definition of well capitalized as recently as July
2008.175
Holding mainly mortgage-backed securities and mortgages in their portfolios, they were uniquely
vulnerable to the decline in the housing market and MBS prices. In July 2008, investor concern
about persistent losses and the potential for future losses led to a sharp decline in stock prices and
cast doubt on their ability to roll over maturing debt. Treasury Secretary Paulson argued that the
solution to this problem was for Congress to grant him what he referred to as a “bazooka”—the
172 Short selling consists of borrowing shares and selling them, in the hope that the short seller can buy back the
borrowed shares at a lower price in the future. A short sale is “naked” if the seller does not actually borrow shares for
delivery to the buyer. For more information, see CRS Report RS22099, Regulation of Naked Short Selling, by Mark
Jickling.
173 Kara Scannell and Tom Lauricella, “SEC Extends Short-Selling Rules,” Wall Street Journal, July 30, 2008, p. C. 1.
174 Limits on OFHEO’s powers and independence are discussed in CRS Report RL32069, Improving the Effectiveness
of GSE Oversight: Legislative Proposals in the 108th Congress, by Loretta Nott and Mark Jickling.
175 Office of Federal Housing Enterprise Oversight, Statement of OFHEO Director James B. Lockhart, July 10, 2008.
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authority for Treasury to provide the GSEs with unlimited funding. He argued that the bazooka
would calm investor fears, and as a result would not need to be used. Congress provided this
authority in the Housing and Economic Recovery Act (P.L. 110-289).
By September 2008, the government decided to take the GSEs into conservatorship following
further losses.176 Conservatorship means that the government has assumed the normal powers of
the officers, board of directors, and shareholders, but the GSEs would continue business
operations. In addition, the government would purchase their MBS and inject as much capital as
needed to keep the firms solvent. In return, the government received warrants to purchase 79.9%
of the companies’ common stock, which would dilute existing shareholders when exercised.
Management was also replaced and dividends on preferred shares were eliminated, but creditors,
including subordinated debt holders, and counterparties suffered no losses.
One rationale for placing the GSEs in conservatorship was that their dominant role in mortgage-
backed securities markets could not have been replaced quickly by the private sector given the
housing downturn. Without them, mortgage credit would have become less available, placing
further downward pressure on the housing market. Another rationale was the potential for
contagion to counterparties and creditors given the large amount of GSE debt and GSE-
guaranteed MBS outstanding.
To bridge the gap between the companies’ assets and liabilities, the government provided $187.5
billion to the companies in exchange for preferred shares between 2008 and 2012. The
government received $55 billion of dividends on those shares through 2012. Since then, the
GSEs’ assets have matched their liabilities and no further preferred share issuance has been
needed. Under the existing agreement, the GSEs’ profits (after dividend payments) would have
accumulated in their coffers.177 Treasury announced in August 2012 that, “(a)cting upon the
commitment ... that the GSEs will be wound down and will not be allowed to retain profits,
rebuild capital, and return to the market in their prior form,” the preferred share agreements had
been amended to replace the dividend and commitment fee with a “net income sweep” that would
remit all profits to the Treasury.178 Regardless of the amount remitted, the terms of the sweep do
not allow for a reduction in the preferred shares outstanding. Thus, while Treasury has not
recouped any principal, it earned a cumulative $202.8 billion in income through the first quarter
of 2014—more than it outlayed.
In economic terms, the subsidy to the GSEs, which takes into account future losses and the
opportunity cost inherent in the GSEs’ ability to borrow at below market rates, was estimated by
CBO to be $291 billion through 2009. Since this estimate was made in August 2009, the state of
the housing market has improved considerably, which could reduce expected defaults and thus the
size of the subsidy, were CBO to update its estimate. In addition, CBO assumes that the
companies will continue to do business at below-market costs in the future that will lead to future
subsidies from the government.179
176 For more information, see CRS Report RL34661, Fannie Mae’s and Freddie Mac’s Financial Problems, by N. Eric
Weiss.
177 For more information, see Federal Housing Finance Agency, U.S. Treasury Support for Fannie Mae and Freddie
Mac,” Mortgage Market Note, no. 10-1, Jan. 20, 2010.
178 U.S. Treasury, “Treasury Department Announces Further Steps to Expedite Wind Down of Fannie Mae and Freddie
Mac,” press release, August 16, 2012. The agreement allows the GSEs to build a capital reserve of $3 billion.
179 Congressional Budget Office, The Budgetary Cost of Fannie Mae and Freddie Mac, Testimony before the
(continued...)
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Between December 2008 and March 2010, the Fed purchased $67 billion of debt issued by
Freddie Mac and $67 billion issued by Fannie Mae as part of its “Large Scale Asset Purchases”
(popularly known as quantitative easing). While the asset purchases were intended to provide
support to mortgage markets and to stimulate overall economic conditions, another effect of these
purchases was to reduce the GSEs’ borrowing costs, all else equal. As these assets have matured,
the Fed’s holdings have declined over time. The Fed faces no default risk on its GSE holdings as
long as the Treasury continues to stand behind the GSEs, and will not experience capital losses
(or gains) as long as it continues to hold the securities to maturity. The Treasury and Fed have
also purchased debt and MBS issued by the GSEs since 2008. The MBS purchases were made at
market prices on the secondary market, so the purchases conferred no direct benefit to the GSEs,
but had the effect of indirectly raising the price received by the GSEs for their MBS.
Lehman Brothers
Shortly after the failures of Fannie Mae and Freddie Mac, the investment bank Lehman Brothers
experienced a liquidity crisis. Lehman Brothers was the 47th-largest firm by revenues in 2007 on
Fortune Magazine’s Fortune 500 list.180 Lehman Brothers was not a bank holding company
regulated for safety and soundness, nor subject to the FDIC’s resolution regime. Lehman Brothers
was a unitary thrift holding company under OTS umbrella supervision; OTS was focused mainly
on the health of the depository subsidiaries. It also complied with an SEC net capital rule.181
Policy makers decided to allow Lehman Brothers to file for bankruptcy when it became clear that
no other firm was willing to acquire the firm without government assistance. According to
Bankruptcydata.com, Lehman Brothers was the largest firm by assets ever to file for
bankruptcy.182
Lehman Brothers was larger than Bear Stearns and was involved in similar business lines. Bear
Stearns had been saved with government assistance, and many market participants were surprised
that a similar arrangement was not made for Lehman Brothers. Unlike Bear Stearns, Lehman
Brothers had access to Fed lending facilities (created after the Bear Stearns crisis), but did not
have enough collateral under the terms of the Fed program to borrow enough to meet its liquidity
needs at the time of its failure. (This problem did not arise when the Fed rescued AIG the next
day.) Policy makers argued that markets should not have expected government assistance because
they had stressed since the Bear Stearns intervention that similar assistance could not be expected
in the future and that failures were necessary to prevent moral hazard problems. Policy makers
also argued that Lehman Brothers had plenty of time to defend themselves from the fate suffered
by Bear Stearns by raising more capital and long-term liquidity. (Lehman Brothers did raise some
in the summer of 2008.) Policy makers believed that they and counterparties were now well
enough prepared for a counterparty failure that systemic risk could be contained.183
(...continued)
Committee on the Budget, U.S. House of Representatives, June 2011.
180 List can be accessed at http://money.cnn.com/magazines/fortune/fortune500/2007/full_list/index.html.
181 For more information, see CRS Report R43087, Who Regulates Whom and How? An Overview of U.S. Financial
Regulatory Policy for Banking and Securities Markets, by Edward V. Murphy.
182 http://www.bankruptcydata.com/Research/Largest_Overall_All-Time.pdf.
183 For example, see Chairman Ben Bernanke, “Lessons from the Failure of Lehman Brothers,” testimony before the
Committee on Financial Services, U.S. House of Representatives, April 20, 2010, http://www.federalreserve.gov/
newsevents/testimony/bernanke20100420a.htm. Thomas Baxter, testimony before the Financial Crisis Inquiry
Commission, September 1, 2010, http://fcic-static.law.stanford.edu/cdn_media/fcic-testimony/2010-0901-Baxter.pdf.
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Some point to the complex, lengthy nature of Lehman Brothers’ bankruptcy proceedings as
evidence that Lehman Brothers was too big to fail, while others argue that bankruptcy
proceedings have gone relatively smoothly and are successfully resolving the claims of creditors
and counterparties in an orderly fashion.184 A New York Fed study finds that creditors received an
unusually low recovery rate from the Lehman bankruptcy.185
Where Lehman Brothers’ failure proved more disruptive to financial markets was through its
effects on money market mutual funds (MMF) and the commercial paper market. On September
16, 2008, a MMF called the Reserve Fund “broke the buck,” meaning that the value of its shares
had fallen below face value. This occurred because of losses it had taken on short-term debt
issued by Lehman Brothers, which filed for bankruptcy on September 15, 2008. Money market
investors had perceived “breaking the buck” to be highly unlikely, and its occurrence set off a run
on money market funds, as investors simultaneously attempted to withdraw an estimated $250
billion of their investments—even from funds without exposure to Lehman Brothers.186 MMFs
are major investors in commercial paper, so this run greatly decreased the demand for new
commercial paper.187 Firms rely on the ability to issue new debt to roll over maturing debt to meet
their liquidity needs. A blanket federal guarantee of MMFs and three Federal Reserve commercial
paper programs were created to restore calm to these markets.188
Contagion from Lehman Brothers’ failure also spread to its three remaining independent “bulge
bracket” investment bank rivals, Merrill Lynch, Morgan Stanley, and Goldman Sachs. All three
experienced liquidity strains following Lehman Brothers’ failure, which all three survived, but
only after fundamental changes to their business models. Merrill Lynch merged with Bank of
America under financial strain, which would cause problems for Bank of America in the ensuing
months. Goldman Sachs and Morgan Stanley changed their charters to become bank holding
companies, under the umbrella supervision of the Federal Reserve. All three relied heavily on
broadly based federal facilities to weather the storm. Borrowing from the Fed’s Primary Dealer
Credit Facility peaked at $48 billion for Morgan Stanley and $40 billion for Merrill Lynch on
September 26, 2008, and at $17 billion for Goldman Sachs on October 10, 2008. All three firms
also accessed the Fed’s Term Securities Lending Facility throughout the fall and its Commercial
Paper Funding Facility beginning in late October. Morgan Stanley and Goldman Sachs each
received $10 billion in exchange for preferred shares through TARP’s Capital Purchase Program
on October 28, 2008, and $10 billion of CPP funds for Merrill Lynch were received by Bank of
America after their merger.
184 See CRS Report R40928, Lehman Brothers and IndyMac: Comparing Resolution Regimes, by David H. Carpenter.
185 Michael Fleming and Asani Sarkar, “The Failure Resolution of Lehman Brothers,” Federal Reserve Bank of New
York, Economic Policy Review, vol. 20, no. 2, March 2014.
186 Figure cited in Fed Chairman Ben Bernanke, “Financial Reform to Address Systemic Risk,” speech at the Council
on Foreign Relations, March 10, 2009, http://www.federalreserve.gov/newsevents/speech/bernanke20090310a.htm.
187 There is debate over whether the money market run triggered by Lehman Brothers’ bankruptcy should be
considered to be caused by Lehman Brothers being TBTF. The view that attributes the run to TBTF interprets the run
as triggered by concerns about the exposure of Lehman Brothers counterparties. The alternative view is that the run
was triggered by concerns about holding paper issued by any financial firm with exposure to “toxic” MBS. Neither
view is inconsistent with the fact that many of the funds that experienced runs were not holding paper issued by
Lehman Brothers. See, for example, Daniel Tarullo, “Regulating Systemic Risk,” speech at 2011 Credit Markets
Symposium, Charlotte, North Carolina, March 31, 2011, http://www.federalreserve.gov/newsevents/speech/
tarullo20110331a.htm.
188 This section draws on information from CRS Report R41073, Government Interventions in Response to Financial
Turmoil, by Baird Webel and Marc Labonte.
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Although the Fed was not willing to rescue Lehman Brothers, it provided Lehman Brothers with
liquidity for a short time to ease the bankruptcy process.189 Lehman Brothers borrowed an
average of $23 billion each day from the Fed’s Primary Dealer Credit Facility, a broadly based
emergency facility, from September 15, the day it filed for bankruptcy, to September 17, 2008.190
Lehman Brothers also borrowed from the Fed’s Term Securities Lending Facility frequently from
March 2008 to September 12, 2008.
AIG
At the same time as the failure of Lehman Brothers, American International Group (AIG) ran into
liquidity problems as a result of collateral calls on its credit default swaps and securities lending
program.191
AIG is a large financial firm operating domestically and abroad; at the time of the crisis, its
insurance operations were the fifth largest in the world. While AIG is often thought of as an
insurance company, it was a complex financial institution with many different types of
subsidiaries, such as AIG Financial Products, which Fed Chairman Bernanke reportedly likened
to a hedge fund.192 Its overall legal structure was a unitary thrift regulated by the Office of Thrift
Supervision (OTS), although its thrift operations were relatively small. AIG’s insurance
subsidiaries were regulated at the state level. Losses were centered in the Financial Products
subsidiary and its securities lending program; as its umbrella regulator, OTS was focused mainly
on the health of the depository subsidiaries. OTS has testified that it did not fully foresee the
potential losses that transactions undertaken by AIG Financial Products posed to the holding
company.193
Unlike Lehman Brothers, policy makers decided that the systemic risk implications of an AIG
failure were too great. AIG was listed as the 10th-largest firm by revenues in 2007 on Fortune
Magazine’s Fortune 500 list.194 On September 16, 2008, the Fed announced that it was taking
action to support AIG. Using emergency authority, this support took the form of a secured two-
year line of credit with a value of up to $85 billion and a high interest rate (set at 8.5 percentage
points above the London Interbank Offered Rate). Although the Fed denied assistance to Lehman
Brothers on the grounds that it lacked acceptable collateral, the loan to AIG was collateralized by
the general assets of AIG.195 In addition, the government received warrants to purchase up to
79.9% of the equity in AIG.
Once the determination to assist AIG had been made, assistance arguably became open-ended,
and more government assistance was provided on several subsequent occasions. On October 8,
189 Thomas Baxter, testimony before the Financial Crisis Inquiry Commission, September 1, 2010, http://fcic-
static.law.stanford.edu/cdn_media/fcic-testimony/2010-0901-Baxter.pdf.
190 Data from http://www.federalreserve.gov/newsevents/reform_pdcf.htm.
191 See CRS Report R40438, Federal Government Assistance for American International Group (AIG), by Baird Webel
192 Craig Torres and Hugh Son, “Bernanke Says Insurer AIG Operated Like a Hedge Fund,” Bloomberg, March 3,
2009.
193 Scott Polakoff, Testimony before the Subcommittee on Capital Markets, Insurance, and Government Sponsored
Enterprises, House Committee on Financial Services, U.S. House of Representatives, March 18, 2009,
http://www.house.gov/apps/list/hearing/financialsvcs_dem/ots_3.18.09.pdf.
194 List can be accessed at http://money.cnn.com/magazines/fortune/fortune500/2007/full_list/index.html.
195 Chairman Ben Bernanke, Testimony Before the House Committee on Financial Services, March 24, 2009.
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2008, the Fed announced that it would lend AIG up to an additional $37.8 billion against
securities held by its insurance subsidiaries. These securities had been previously lent out and
were not available as collateral at the time of the original intervention, increasing AIG’s cash flow
problems. In October 2008, AIG also announced that it had applied to the Fed’s general
Commercial Paper Facility and was approved to borrow up to $20.9 billion at the facility’s
standard terms.
The financial support for AIG was restructured in early November 2008. The restructured
financial support included up to a $60 billion loan from the Fed, with the term lengthened to five
years and the interest rate reduced by 5.5 percentage points; $40 billion in preferred share
purchases through the TARP through a new program created for AIG called the “Systemically
Significant Failing Institutions Program”; up to $52.5 billion total in asset purchases by the Fed
through two Limited Liability Corporations (LLCs) known as Maiden Lane II and Maiden Lane
III. AIG contributed an additional $6 billion for the LLCs and will bear the first $6 billion in any
losses on the asset values. By 2012, the Maiden Lanes had received more from asset sales than
the Fed had contributed to their purchases. Principal and interest were recouped, and further gains
from these LLCs were shared between the Fed and AIG.
The 79.9% common equity position of the government in AIG remained essentially unchanged
after the restructuring of the intervention, although assistance was increased. Additional
restructurings were announced in March 2010 and September 2010. In the latter restructuring, the
Federal Reserve loan was repaid in full and the preferred shares were converted into common
equity. This increases the risk and potential reward for the government from its AIG holdings
since the common equity can rise or fall in value based on market conditions and the future
financial performance of AIG. Warrants initially valued at $1.2 billion were also issued to AIG’s
private shareholders at this time, transferring value from the government to shareholders. The
government sold its common equity stake between May 2011 and December 2012.
With each restructuring, costs were reduced for AIG and risks were shifted away from AIG to the
government. Policy makers initially provided loans with very high interest rates out of moral
hazard concerns, but found that punitive conditions decreased the ongoing viability of the
company (and, hence, the probability that the assistance would be repaid). Therefore, when
assistance was revised, conditions typically became less punitive. Since the government held
92.6% of the common stock in AIG at the peak, however, a case can be made that the benefits of
any restructuring that improves AIG’s future profitability mostly accrues to the government.
On a cash-flow basis, the Fed and Treasury combined ultimately received $23 billion more than
they outlayed to AIG. Whether this resulted in an economic profit for the federal government or a
subsidy to AIG depends on the opportunity cost of those funds, based on the risks that the
government undertook and the time value of money. CBO has made such a calculation, and
estimates that the TARP portion of the assistance to AIG will have a net cost of $15 billion over
the lifetime of the assistance.196 At the time of the Fed’s intervention, CBO estimated a $2 billion
subsidy for the Fed portion of the assistance; since the Fed’s intervention turned out to be cash-
flow positive and CBO has revised downward its estimates of TARP subsidies over time, that
amount could be re-estimated downward if CBO were to update it.
196 Congressional Budget Office, Report on the Troubled Asset Relief Program, April 2014, Table 3.
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Washington Mutual and Wachovia
Two large banks, Washington Mutual and Wachovia, were successfully resolved by the FDIC
through mergers during the 2008 crisis, at no cost to the taxpayers.
Washington Mutual was a thrift holding company. Its depository subsidiary experienced depositor
runs in 2008 following losses. It was the 81st-largest firm by revenues in 2007 on Fortune
Magazine’s Fortune 500 list and the largest thrift holding company.197 Depositors withdrew $9.4
billion between July 12 and July 30, and $15 billion between September 11 and 26—the closest
the 2008 crisis saw to a traditional bank run.198 On September 25, the thrift was taken into
receivership by the FDIC. It was resolved through a purchase and assumption agreement with J.P.
Morgan Chase. As part of the agreement, J.P. Morgan Chase paid $1.9 billion to assume the
claims of uninsured depositors, counterparties with qualified financial contracts, and secured
creditors; it did not assume the claims of unsecured creditors or equity holders.199 The remainder
of the company filed for bankruptcy on September 26. Thus, the receivership required no federal
funds, and the moral hazard problem was mitigated since unsecured creditors and equity holders
suffered losses. J.P. Morgan Chase’s willingness to pay to assume other liabilities implies that it
believed the remaining assets were sufficient to honor those liabilities.
Washington Mutual received a $1 billion, 28-day loan from the Federal Reserve’s Term Auction
Facility on September 11, 2008. The bank was closed by the FDIC on September 25, 2008, and
the loan was repaid after its merger. Since the loan was fully collateralized and the Fed receives
priority ahead of other creditors, it appears to have posed little risk to the taxpayers in the face of
receivership. Nonetheless, the loan appears to have been a departure from Fed policy since the
Fed’s broadly based lending programs were intended to provide liquidity to solvent firms.
Washington Mutual could be seen as an example of a TBTF bank that experienced an orderly
resolution through the FDIC’s resolution regime at no cost to the taxpayers. Or it could be seen as
too small to be relevant to the TBTF debate.
Wachovia (the 46th-largest firm on Fortune Magazine’s Fortune 500 list in 2007) faced runs soon
after Washington Mutual failed. According to Federal Reserve testimony,
The day after the failure of WaMu, Wachovia Bank depositors accelerated the withdrawal of
significant amounts from their accounts. In addition, wholesale funds providers withdrew
liquidity support from Wachovia. It appeared likely that Wachovia would soon become
unable to fund its operations.200
197 List can be accessed at http://money.cnn.com/magazines/fortune/fortune500/2007/full_list/index.html. Scott G.
Alvarez, “The Acquisition of Wachovia Corporation by Wells Fargo & Company,” Testimony Before the Financial
Crisis Inquiry Commission, Washington, D.C., September 1, 2010.
198 Kirsten Grind, “WaMu’s Final Days,” Puget Sound Business Journal, Friday, September 25, 2009,
http://seattle.bizjournals.com/seattle/stories/2009/09/28/story1.html?page=1.
199 Federal Deposit Insurance Corporation, “JPMorgan Chase Acquires Banking Operations of Washington Mutual,”
Press Release PR-85-2008, September 25, 2008.
200 Scott G. Alvarez, “The Acquisition of Wachovia Corporation by Wells Fargo & Company,” Testimony Before the
Financial Crisis Inquiry Commission, Washington, D.C., September 1, 2010, http://www.federalreserve.gov/
newsevents/testimony/alvarez20100901a.htm.
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According to the Fed, problems at Wachovia were unforeseen, making the bank both a victim and
a potential transmitter of contagion:
At the time, Wachovia was considered “well capitalized” by regulatory standards and until
very recently had not generally been thought to be in danger of failure, so there were fears
that the failure of Wachovia would lead investors to doubt the financial strength of other
organizations in similar situations, making it harder for those institutions to raise capital and
other funding.201
On September 27 and 28, Wells Fargo and Citigroup placed competing bids to acquire Wachovia.
Initially, those bids were contingent on federal assistance. FDIC assistance under the systemic
risk exception to least cost resolution had been approved.202 Later, Wells Fargo revised its offer,
acquiring Wachovia without federal assistance and averting a receivership.
Neither the Washington Mutual nor the Wachovia acquisitions were found to breach the Riegle-
Neal 10% nationwide deposit cap. JP Morgan Chase’s acquisition of Washington Mutual’s
deposits and other assets occurred through an FDIC purchase and assumption arrangement. The
10% deposit cap does not apply to an FDIC purchase and assumption. In its approval of Wells
Fargo’s acquisition of Wachovia, the Fed noted that using the most current data, the merged entity
would be above the 10% deposit limit. The Fed then argued that since that data were released
with a lag, projections of current deposit data indicated that the merger would probably fall below
the 10% cap.203
Although the Fed’s Term Auction Facility was intended for healthy firms, Wachovia received nine
Term Auction Facility loans between September 11, 2008, and February 26, 2009, including $5
billion on September 25, 2008, one day before the run on Wachovia began. Its merger with Wells
Fargo was announced on October 3, 2008.
TARP, Citigroup, Bank of America, and the Stress Tests
The first and largest program initiated under the Troubled Asset Relief Program (TARP) was the
Capital Purchase Program (CPP).204 The purpose of the CPP was to provide banks and bank
holding companies (BHC) with preferred shares to increase their capital buffers against future
losses at a time when it was difficult for banks to access private capital. The CPP was intended
for healthy banks of all sizes and unsuitable candidates were rejected. Therefore, it does not
closely match the definition of bailout used in this report, which implies assistance to unhealthy
firms, or TBTF assistance. Nevertheless, CPP funds went to banks that later failed (14 mostly
small banks, as of December 2011)205 and the first recipients were the nine largest BHCs, all of
whom had fully repaid CPP shares by 2010. If limited to healthy banks and purchased at market
rates, preferred shares impose limited risk on taxpayers. Despite the handful of losses on CPP
201 Ibid.
202 Ibid.
203 Federal Reserve, “Statement by the Board of Governors of the Federal Reserve System Regarding the Application
and Notices by Wells Fargo and Company to Acquire Wachovia Corporation,” October 12, 2008, p. 7,
http://www.federalreserve.gov/newsevents/press/orders/orders20081021a1.pdf.
204 For more information on all TARP programs, see CRS Report R41427, Troubled Asset Relief Program (TARP):
Implementation and Status, by Baird Webel.
205 U.S. Department of Treasury, TARP Monthly 105(a) Report – December 2011, January 2012. The largest failure
was CIT Group, with $76 billion in consolidated assets in the first quarter of 2009.
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investments in small banks, CBO has estimated that the government will ultimately earn an
overall economic profit (i.e., earn an above market rate of return) from the CPP from dividends
and warrants. In October 2012, CBO estimated that profit to be $18 billion.206
After the initial disbursement of CPP funds, Citigroup and Bank of America received additional
TARP capital injections and asset guarantees for their balance sheet holdings through a special
TARP program with no other recipients. The additional capital paid a higher dividend rate than
the CPP shares. Other TARP programs included programs to assist AIG (discussed above) and the
automakers. As will be discussed, the program for automakers was used to provide special
assistance to two financial firms, Chrysler Financial and GMAC (later renamed Ally Financial).
Following the additional TARP capital injections, Citigroup remained well capitalized according
to regulatory standards.207 It appears that without TARP funds Citigroup would have fallen to
slightly below the Fed’s minimum Tier 1 Leverage requirements of 4% at the end of 2008,
assuming they had not raised private capital in the absence of TARP funds.208 Regulations require
BHCs to submit a plan to the Fed in a timely manner if they fall below minimum capital
requirements.209 In February 2009, Citigroup and the federal government reached an agreement to
convert up to $27.5 billion of Citigroup’s TARP preferred shares into common equity. This
agreement had the result of boosting Citigroup’s common equity ratios and ending dividend
payments to the government.210 It also exposed the government to greater risk and potentially
greater return on its investments, since common equity can rise and fall in value, unlike the TARP
preferred shares. Citigroup was the largest financial firm in the country and eighth-largest firm
overall on Fortune Magazine’s 2007 Fortune 500 list.211
Bank of America’s financial problems centered mainly on its acquisitions of Countrywide and
another very large financial firm, the investment bank Merrill Lynch. At the time of the Lehman
Brothers crisis, Merrill Lynch also came under financial pressure as a result of its similar business
model, forcing it to seek a merger partner. Merrill Lynch (the 22nd-largest firm on Fortune
Magazine’s Fortune 500 list in 2007) was larger than either of those firms. In September 2008,
Bank of America and Merrill Lynch reached an agreement in principle to merge. As financial
conditions deteriorated further, Bank of America considered pulling out of the merger. To prevent
this, according to the Treasury Secretary at the time, the government agreed to purchase another
$20 billion of preferred shares through TARP and enter into a federal asset guarantee
agreement.212 The merger was finalized in January 2009, and Bank of America received the
206 Congressional Budget Office, Report on the Troubled Asset Relief Program, October 2012.
207 In their regulatory call reports, banks report capital ratios for three measures: Total Risk-Based Capital, Tier 1 Risk-
Based Capital, and Tier 1 Leverage. For large BHCs, the Fed sets a minimum Tier 1 leverage requirement of 3% of
total assets for banks receiving the highest regulatory rating and 4% of total assets for all other firms (12 CFR 225
Appendix D). The regulatory rating that firms receive is confidential. For Tier 1 Risk-Based Capital and Total Risk-
Based Capital, respectively, the Fed sets minimum requirements of 4% and 8% of risk-weighted assets.
208 At the holding company level, Citigroup reported $118.8 billion of Tier 1 Capital in its December 2008 call report;
of this total, $45 billion was from TARP. An estimate for the other two regulatory capital ratio measures cannot be
easily calculated.
209 12 CFR Part 225, Subpart J.
210 Citigroup, “Citi to Exchange Preferred Securities for Common, Increasing Tangible Common Equity to as Much as
$81 Billion,” press release, February 27, 2009, http://www.citigroup.com/citi/press/2009/090227a.htm.
211 List can be accessed at http://money.cnn.com/magazines/fortune/fortune500/2007/full_list/index.html.
212 Henry Paulson, Testimony before the Committee on Oversight and Government Reform, U.S. House of
Representatives, July 16, 2009, posted at http://online.wsj.com/public/resources/documents/WSJ-20090715-
PaulsonTestimony.pdf.
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additional TARP shares shortly thereafter; the asset guarantee was never finalized. In its March
2009 call report, Bank of America remained well capitalized according to regulatory standards.213
It appears that even without TARP funds Bank of America would have remained above the Fed’s
minimum Tier 1 leverage requirements of 4% in that quarter.214
In May 2009, the Federal Reserve released the results of the Supervisory Capital Assessment
Program, its “stress tests” for the 19 largest bank holding companies.215 The stress tests were
meant to determine whether these banks would remain well capitalized in the event of a downside
economic scenario. The tests required banks to be able to maintain Tier 1 Risk-Based Capital of
6% and Tier 1 Common Capital of 4% in this scenario. Of the participants, 10 of 19 were found
to be well capitalized against future losses; of those 10, the 9 participating in TARP bought back
their preferred shares and exited the program shortly thereafter. Of the other nine that required
additional capital to withstand hypothetical losses under the adverse scenario, seven (including
Bank of America, which was required to raised $33.9 billion) were able to raise the needed capital
without government funds; GMAC required TARP funds (through the Automotive Industry
Financing Program) to raise the needed capital; and Citigroup, which was required to raise $5.5
billion, met the threshold for Tier 1 Common Capital in part by converting more of its existing
CPP preferred shares into common shares. After the preferred shares were converted to common
equity, the government owned about one-third of the company.216
In December 2009, Citigroup bought back $20 billion of TARP preferred securities outstanding,
replacing those shares with private capital, and terminated the government’s asset guarantee for a
fee. In March 2010, the Treasury announced plans to dispose of its common shares in Citigroup
by the end of the year. The government ultimately sold these shares for $31.9 billion, or $6.9
billion more than the initial assistance extended. Treasury reports that for the three programs
assisting Citigroup combined, it had a positive cash flow of $13.4 billion.217
In December 2009, Bank of America repurchased all of its TARP preferred shares, replacing
those shares with private capital, and paid a fee to cancel the asset guarantee that was negotiated
but never entered into.
The experience with Bank of America and Citigroup is quite different from the experience with
AIG and the GSEs. While TARP funds kept Bank of America’s and Citigroup’s capital levels
above the minimally required level, neither firm is believed to have been close to insolvency—
213 The first quarter of 2009 was the first call report to incorporate TARP shares and the Merrill Lynch merger. In their
regulatory call reports, banks report capital ratios for three measures: Total Risk-Based Capital, Tier 1 Risk-Based
Capital, and Tier 1 Leverage. For large BHCs, the Fed sets a minimum Tier 1 leverage requirement of 3% of total
assets for banks receiving the highest regulatory rating and 4% of total assets for all other firms (12 CFR 225 Appendix
D). The regulatory rating that firms receive is confidential. For Tier 1 Risk-Based Capital and Total Risk-Based
Capital, respectively, the Fed sets minimum requirements of 4% and 8% of risk-weighted assets.
214 At the holding company level, Bank of America reported $117.9 billion of Tier 1 Capital in its December 2008 call
report; of this total, $45 billion was from TARP. An estimate for the other two capital ratio measures cannot easily be
calculated.
215 Federal Reserve, The Supervisory Capital Assessment Program: Overview of Results, May 7, 2009. For an
evaluation, see Special Inspector General for Troubled Asset Relief Program, Exiting TARP: Repayments by the
Largest Financial Institutions, SIGTARP report 11-005, September 29, 2011.
216 Citigroup, Supervisory Capital Assessment Program Results – Update on Exchange Offer, May 7, 2009,
http://www.citigroup.com/citi/fin/data/p090507a.pdf.
217 U.S. Treasury, “Treasury Prices Sale of Citigroup Subordinated Notes for Proceeds of $894 Million,” press release,
February 5, 2013.
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although it is unknown what would have happened to Merrill Lynch had Bank of America not
acquired it. Bank of America repaid TARP funds in full in December 2009, and the government
fully divested from Citigroup in 2010. CBO has estimated that the government earned an
economic profit, calculated using a risk-adjusted discount rate, of $8 billion from its special
assistance to the two companies.218
GMAC
While Congress authorized TARP to “purchase, and to make and fund commitments to purchase,
troubled assets from any financial institution, on such terms and conditions as are determined by
the Secretary, and in accordance with this Act and the policies and procedures developed and
published by the Secretary,” TARP funding was also used to facilitate the bankruptcy process for
GM and Chrysler.219 Economists have generally focused on financial firms as being TBTF
because of the interconnectedness inherent in financial intermediation; determining whether
automakers can be TBTF is beyond the scope of this report.
In conjunction with the automakers, two financial firms related to the automakers, GMAC and
Chrysler Financial, also received TARP assistance. Chrysler Financial was a relatively small
financial firm, and it repaid its $1.5 billion TARP loan in full with interest by July 2009. GMAC
received several rounds of TARP funding in order to return its capital levels to acceptable levels.
After converting to a bank holding company during the crisis, GMAC was the 10th-largest bank
holding company, with $180 billion in assets, in the first quarter of 2009. It dominated dealer
floorplan financing for GM and Chrysler, and reportedly had three times the market share of its
five largest competitors in auto financing.220
TARP first purchased $5 billion of GMAC preferred shares in December 2008 and lent $884
million to GM, which was later transferred to GMAC, as part of the initial assistance provided to
the automakers. As discussed above, GMAC was one of the nine bank holding companies that
were required to raise additional capital under the May 2009 stress tests. It was the only one of
those nine that raised the capital through additional TARP disbursements, rather than through
private markets. The government purchased an additional $7.5 billion of preferred shares and
converted the $884 million loan into 35.4% of GMAC’s common equity in May 2009. The
government then purchased $2.54 billion of trust preferred securities and an additional $1.25
billion of preferred shares in December 2009. At the same time, it converted $3 billion in
preferred shares for 20.9% of GMAC’s common equity. In December 2010, it converted an
additional $5.5 billion of preferred shares into 17.5% of GMAC’s common equity; $5.9 billion of
preferred shares remain outstanding, and the government has sold the trust preferred securities to
private investors at face value. This made recoupment of funds for the government dependent on
the future value of GMAC (renamed Ally Financial).221 To date, the government has sold its
preferred shares back to GMAC and some of its common stock to private investors. Although the
government still holds shares, the proceeds from share sales plus income received less writeoffs
to date has slightly exceeded its total initial outlays. CBO does not estimate a separate subsidy
218 Congressional Budget Office, Report on the Troubled Asset Relief Program, April 2014.
219 More information can be found in out-of-print CRS Report R40003, U.S. Motor Vehicle Industry: Federal Financial
Assistance and Restructuring, coordinated by Bill Canis, available upon request.
220 Congressional Oversight Panel, January Oversight Report, January 13, 2011, p. 82.
221 CRS Report R41846, Government Assistance for GMAC/Ally Financial: Unwinding the Government Stake, by
Baird Webel and Bill Canis.
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cost for the government’s assistance to GMAC, but estimates “a small net cost” for assistance to
GMAC and Chrysler Financial combined.222
Author Contact Information
Marc Labonte
Specialist in Macroeconomic Policy
mlabonte@crs.loc.gov, 7-0640
Acknowledgments
The author would like to thank Darryl Getter, Mark Jickling, Edward Murphy, Maureen Murphy, Baird
Webel, and Eric Weiss for helpful comments and assistance.
222 Congressional Budget Office, Report on the Troubled Asset Relief Program, April 2014, p. 6.
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