INTERNATIONAL FINANCIAL

International Financial Crises and Bank Regulation

International Financial Crises and Bank Regulation

Introduction

Banks play a central role in the economy by providing credit to individuals and businesses, and offering services, such as deposits, and by facilitating payments for goods and services. If its depositors withdraw their funds on the belief that the bank is on the verge of insolvency, it could be forced to sell off its assets at “fire sale” prices, thereby turning an illiquidity problem into a solvency problem. Such a run could trigger similar runs on other institutions and drive them all into insolvency. This state of affairs could lead to a disruption in the payments system and a tightening of available credit, with an adverse macroeconomic impact. To address issues of systemic risk in the banking system, Congress established the Federal Reserve in December 1913.

A major purpose of the Federal Reserve was to act as a lender of last resort by providing funds to solvent banks experiencing liquidity problems. These loans were to be made against good collateral, defined by the Federal Reserve Act as secured “to the satisfaction of the Federal Reserve.” Twenty years later, in June 1933, Congress created the FDIC, its purpose being to guarantee deposits, up to a limit, to lessen the incentive of depositors to make panicked withdrawals and thereby to reduce the likelihood of bank runs.

Discussion

Concept of the Too-Big-To-Fail

The Too-Big-To-Fail concept applies to banks whose uninsured creditors are perceived as being very likely to benefit from discretionary government support to which they are not formally entitled (as would be the case for insured depositors, for example) and for which they do not pay. TBTF is typically seen as an implicit government guarantee that goes beyond explicit deposit insurance programs since governments usually do not state in advance which creditors will benefit from the application of TBTF, nor do they charge for the guarantee (www.icffr.org/g).

TBTF, however, is a bit of misnomer. First, TBTF is aimed at benefiting a bank's creditors, not its shareholders (although such actions allow the bank and often its current management to continue operating). Second, it is not always the size of the bank that determines whether its creditors will be the beneficiaries of discretionary government assistance. The authorities often extend TBTF support to the creditors of a bank that offers a unique or important financial function such as providing special services to the securities markets or payment systems, or is a key participant in interbank markets or other markets with a limited number of participants. In these circumstances, some commentators refer to such banks as Too Complex To Fail, Too Big To Liquidate Quickly, Too Important (or Special or Political) To Fail or Too Difficult to Fail and Unwind. But whatever the practice is called, it results in the same outcome-uninsured creditors of the bank benefit from discretionary government support provided at the expense of the taxpayer (search.proquest.com/).

As noted earlier, the government defended its 1984 bailout of Continental Illinois citing concerns about ...