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Too Big to Fail



Definition

“Too Big to Fail” is a financial term that refers to large corporations or institutions viewed as so interconnected or important to the global economy that their failure would cause a drastic economic downturn. As a result, these businesses may be supported by governments in times of crisis to avoid such consequences. The term is often used in the context of financial bailouts, particularly within the banking industry.

Phonetic

/tuː bɪg tʊ feɪl/

Key Takeaways

  1. “Too Big to Fail” often refers to large corporations, particularly financial institutions, whose failure would have a disastrous impact on the economy. As such, governments are often compelled to save these entities to prevent economic turmoil.
  2. This concept can foster a dangerous atmosphere of moral hazard. Large corporations may take on excessive risk, knowing they will likely be rescued if troubles arise. This encourages reckless financial behavior with potentially serious economic consequences.
  3. Various strategies have been suggested to handle “Too Big to Fail” firms, including increased regulation, breaking up large corporations, or creating a fund paid into by the firms themselves to pay for potential bailouts. However, factoring the risk associated with such firms and the potential adverse effects on the economy, there’s yet to be a fully agreed-upon solution.

Importance

The term “Too Big To Fail” is critical in business/finance because it refers to corporations, usually financial institutions, that are so large and interconnected that their failure would significantly disrupt the economy. Therefore, the government is often compelled to intervene to prevent them from failing, typically through bailouts or additional regulation. This idea became particularly significant during the 2008 financial crisis when several major financial institutions were deemed “too big to fail”. The implications of this principle have far-reaching impacts on policy, business practices, and financial regulations. This concept also raises concerns about moral hazard, where businesses may take on excessive risk because they believe they will be rescued if things go wrong.

Explanation

The phrase “Too Big to Fail” refers to a concept in finance wherein certain companies, particularly large financial institutions, are considered vital to the economy. This notion is evinced when the government steps in to rescue them during turbulent times because their collapse could create a domino effect, triggering widespread economic disaster. Due to their sheer size, interconnectivity, or core function, these firms are deemed pivotal in maintaining financial and economic stability; hence, they are sheltered rather than left to face the brunt of their risky undertakings.The role of the “Too Big to Fail” policy is quite controversial. On one hand, it’s seen as a necessary evil to avert potentially severe economic crises that could stem from one institutional failure. Governments or central banks use it as a strategy to prevent or minimize the fallout that could be catastrophic to national or global economies. On the other hand, critics argue that it encourages reckless behavior by the said institutions. Known as moral hazard, the safety net convinces these organizations to undertake riskier investments or activities, knowing they’ll be bailed out if things go awry, which could eventually lead to systemic risks and financial instability.

Examples

1. General Motors: In 2008, General Motors was on the verge of bankruptcy due to several factors, including the global recession. However, the U.S. government came to the rescue with a $49.5 billion bailout. General Motors was considered “too big to fail,” because its collapse would have caused massive job losses and further harm an already struggling economy. 2. AIG (American International Group): In the same year, during the global financial crisis, AIG, one of the world’s largest insurance firms, was on the brink of failure. It was heavily invested in the subprime mortgage market that was collapsing at the time. The U.S. government stepped in with a bailout package of $180 billion, one of the biggest in history, considering AIG “too big to fail,” fearing its collapse would trigger a series of catastrophic events in the global financial sector.3. Citigroup: Citigroup, an American multinational investment bank and financial services corporation, faced the possibility of failure in 2008 due to its investments in subprime mortgages. The U.S. government intervened, investing $45 billion in the bank and providing a guarantee of almost $300 billion for its risky assets. Citigroup was considered “too big to fail” due to its substantial influence and presence in the American banking system and the potential global financial consequences of its collapse.

Frequently Asked Questions(FAQ)

What does the term Too Big to Fail mean?

Too Big to Fail is a term used in finance to describe a business entity, typically a large and complex financial institution, that has become so integral to the economy that the government will provide assistance or bailouts to prevent its failure.

How does a company become Too Big to Fail?

A company typically becomes Too Big to Fail when its operations are deeply interwoven into the society’s financial and economic system. This means if it were to fail, it could lead to significant economic disruptions or recession.

Does being Too Big to Fail provide any advantages to a company?

It can provide some indirect advantages. Companies labelled as Too Big to Fail can potentially take on more risks, knowing that in the event of a crisis, the government is likely to step in and prevent their collapse to avoid economic distress.

Does the concept of Too Big to Fail only apply to financial institutions?

While the term is predominantly used to refer to large financial organizations, it can also apply to major companies in other industries whose failure could significantly impact the economy.

How does a government determine whether an institution is Too Big to Fail?

There are no set criteria. However, the government typically considers the scale of disruptive effects that the collapse of the institution might have on economic stability, the national or global economic environment, and the overall financial system.

Are there any criticisms of the Too Big to Fail concept?

Yes, the main criticism is that it encourages risky behavior because it gives the institutions confidence that they will be rescued by the government. Critics argue this creates a moral hazard. Furthermore, it can also lead to a lack of competition and increased disparity in the financial sector.

How can the risk of Too Big to Fail be mitigated?

Solutions may include increased regulations and oversight, creating a fund for future bailouts, or breaking up the institution into smaller ones so that the failure of one part doesn’t bring down the entire system.

Are there any examples of Too Big to Fail institutions?

During the 2007-2008 financial crisis, prominent financial institutions like Bear Stearns and AIG were considered Too Big to Fail , leading to massive government bailouts. These cases highlighted the risks and consequences of the Too Big to Fail doctrine.

Related Finance Terms

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