Too Big to Fail

Too big to fail

“Too big to fail” theory asserts that certain corporations, particularly financial institutions, are so large and so interconnected that their failure would be catastrophic to the economic system. Consequently, when such institutions face potential failure, in theory, government must support them to prevent a disastrous situation. The concept has been successful at protecting depositors and detaining the problem of bank panics, because it ensures that depositors are protected, consequently encouraging depositors to put their funds in the bank. However the safety net creates moral hazard problems.  This is because the depositors are aware that bank failure will not affect them, and would not take any action even though the bank is taking too much risk. Also, adverse selection may occur, because big financial institutions will abuse the policy, taking on greater risk than normal, believing that the government will ensure there risky actions.  

Failure of big financial institutions might cause a serious downturn on the overall economic condition. However, market corrections are a vital way of stabilizing the system. In case of the failure of Lehman brothers during the financial crisis in 2008, even though it had a negative impact on the overall economy, the lesson was able to enhance the system of the financial institutions, avoiding the same incident from happening. Moreover, the way of deciding which institutions are too big to fail could be vague. In addition, the money could spent to recue failing firms could be used more efficiently, such as creating more job spaces or helping other important sectors in the country such as education.

I believe that Too big to fail is considered to be a cause of degeneration and corruption of the financial system, because the company will be less reluctant to invest in riskier assets. There are more negative consequences occurring from “Too big to fail” policy, therefore I feel it should restrict the policy or even completely end the system.