The “Too Big to Fail” Problem Still Unsolved

Axel Wieandt / Sascha Hahn  - 29. November 2023

At the height of the global financial crisis, when numerous governments had to rescue banks with equity assistance and guarantees in unprecedented amounts, the international community agreed on one thing: “never again.” Resolved to never let such a crisis come to pass in the future, regulators took numerous measures following the 2009 G20 Summit in Pittsburgh to strengthen the resilience of the global financial system and of banks in particular.

An essential tool of this plan is the elimination of the implicit government guarantees (IGGs) for systemically important banks, i.e., banks considered “too big to fail.” The problem with these guarantees is that creditors of such banks assume that governments cannot allow these institutions to fail—and they know that in times of crisis, these governments are willing to rescue banks with equity assistance and guarantees.  As a result, they factor this into their investment decisions, understanding that, in case of imminent insolvency, these institutions will benefit from IGGs, which can also become explicit government guarantees in the event of a crisis. This can be significantly advantageous for banks. They can benefit from favorable refinancing conditions and can align their portfolio with riskier investments. If everything goes well, investors receive high profits and payouts. If risks materialize, shareholders can trust that their assets will be protected by what is known as a “bailout,” i.e., a state rescue using taxpayer money.

To avoid such outcomes, many efforts were made globally in recent years to establish a suitable resolution mechanism for banks. And ever since, creditors and stockholders have had to participate in actions taken to save a bank from failure. In 2016, such a uniform system was implemented in Europe as well. Yet, in the years that followed, there have been many cases of EU member states recapitalizing banks as a precautionary measure. In the end, the “too big to fail” problem still remains unsolved, and banks today can still rely on government support.

The latest statistical analysis covering the period from 2009 to 2016 reveals the resolutions in Europe have gained little credibility within stock and credit markets—and that it is still generally assumed troubled banks will not simply be resolved. The analysis calculates the abnormal stock returns and credit default swap (CDS) spreads of certain banks during the phase in which measures in Europe were being implemented (2009 – 2017). It considers 34 regulatory announcements for 260 European financial institutions, as well as differences between individual bank groups, e.g., the classification of a financial institution as being systemically important or not.

The results of the analysis show that particularly systemically important European banks continue to benefit from IGGs, as evidenced by the positive reactions of stock prices and CDS spreads to the introduction of the SRM. Yet, banks continue to have misguided incentives to take on high risks. For that reason alone, it is imperative that the resolution mechanism be further developed.

Independent of the European Central Bank or member state, the mechanism should include specific enforcement rights to enable failed banks to be resolved quickly and effectively—all in the interest of European financial stability.

From 2019 to 2020, the Single Resolution Board (SRB) in Brussels, the supreme authority in Europe responsible for the orderly resolution of a failing financial institution, primarily focused on three key areas: making the banks under their jurisdiction more resilient, promoting a robust set of conditions for resolution, and implementing an effective concept for crisis management. In addition, the SRM should be fully operationalized. And although these adjustments have increased the credibility of the European bail-in system (a “bail-in” being when creditors participate in an institution’s recovery and/or resolution), state assistance has yet to be fully abolished. On the contrary, specific exceptional cases have been defined since then in which banks can continue to receive public support.

The European banking union still has a way to go to fully develop. Since the suggestion was made for a harmonized deposit insurance mechanism in 2015, member states have been unable to agree on a common solution. A collective system to protect savers would guarantee that deposit insurance is sufficiently funded throughout all of Europe and that weak deposit insurance does not create an additional incentive for national governments to bail out their domestic banks.

While it is true that the credibility of the European bail-in system has continued to increase since 2017, government bailouts still exist today. Especially with the recent takeover of Silicon Valley Bank and Signature Bank by the FDIC in the United States, and the sale of Credit Suisse to UBS orchestrated by the Swiss government over a weekend —as well as with continued geopolitical challenges, an ever-changing global interest rate landscape, increased inflation rates, and capital markets becoming more volatile—the resilience of Europe’s resolution regime could be put to the test yet again.

Literature reference

Hahn, S./Momtaz, P./Wieandt, A. (2022): The economics of banking regulation in Europe: does the post-GFC bail-in regime effectively eliminate implicit government guarantees?, in: The European Journal of Finance, DOI: 10.1080/1351847X.2022.205888