Origins
The doctrine of “Too Big to Fail” (TBTF) emerged as a practical reality in modern finance when the federal government rescued Continental Illinois National Bank in 1984. The Comptroller of the Currency explicitly stated that certain banks were too large to be allowed to fail because of the systemic consequences. Continental Illinois was larger than all banks that had failed during the Great Depression combined, and regulators concluded its bankruptcy would trigger a contagion capable of destroying the broader financial system.
The term crystallized a policy that had existed implicitly since the founding of the Federal Reserve: the state would intervene to prevent cascading failures in the financial system. What changed in 1984 was the explicit acknowledgment that this protection extended not just to depositors but to all creditors of sufficiently large institutions.
Structure & Function
The TBTF doctrine creates a persistent moral hazard. Creditors of large institutions operate under an implicit government guarantee, believing the state will always intervene to prevent a total default. This expectation lowers the borrowing costs for large firms compared to their smaller competitors, incentivizing banks to grow excessively large and take greater risks.
The doctrine has evolved from protecting traditional deposit-taking banks to including non-bank entities that are deeply entwined in the derivatives and repo markets. Bear Stearns (investment bank), AIG (insurance company), and the money market fund industry all received government support in 2008 based on systemic risk arguments. The “interconnectedness” of modern finance—through derivatives, repo lending, and prime brokerage—means that failure of any major node in the network threatens the entire system.
Historical Significance
The 2008 financial crisis represented both the apotheosis and the crisis of the TBTF doctrine. The failure of Lehman Brothers was intended to reintroduce market discipline by demonstrating that the government would not always intervene. Instead, the subsequent market freeze and global recession largely reinforced the TBTF consensus—the cure proved worse than the disease.
Despite post-crisis legislative attempts to ban bailouts through the Dodd-Frank Act, the lack of a credible, non-disruptive bankruptcy mechanism for complex global firms means the doctrine remains unresolved. The Financial Stability Oversight Council (FSOC) now designates “systemically important financial institutions” (SIFIs), effectively creating an official TBTF list. Critics argue this institutionalizes the problem rather than solving it.
Key Developments
- 1984: The Continental Illinois crisis marks the first explicit use of TBTF doctrine.
- 1991: The FDIC Improvement Act (FDICIA) attempts to limit TBTF but includes a “systemic risk exception.”
- 1998: The Federal Reserve coordinates a private bailout of Long-Term Capital Management (LTCM).
- 2004: The SEC adopts the Consolidated Supervised Entities program, allowing investment banks to use internal models for capital, leading to increased leverage.
- 2008 (March): The Federal Reserve facilitates the takeover of Bear Stearns by JPMorgan Chase.
- 2008 (September 15): Lehman Brothers files for bankruptcy after the government refuses a bailout.
- 2008 (September 16): The U.S. government bails out AIG with an initial $85 billion loan.
- 2008 (October): The Troubled Asset Relief Program (TARP) provides hundreds of billions in capital to the largest banks.
- 2010 (July): The Dodd-Frank Act creates the Financial Stability Oversight Council (FSOC) to monitor systemically important financial institutions.
- 2011: Moody’s downgrades major U.S. banks, noting decreased but still significant probability of government support.
- 2011: The Basel Committee identifies 27 “globally systemically important banks” requiring extra capital buffers.
- 2012: The Federal Reserve Bank of Dallas publishes a report calling for the immediate end of TBTF.