What ‘Too Big to Fail’ Means and Why It Matters

“Too big to fail” became one of the most repeated phrases of the financial crisis. It describes a company so large and so connected to others that its collapse could harm the entire economy, which pushes governments to rescue it. This article explains the idea, the problems it creates and the debate it started.

The basic idea

Most businesses can fail without wider consequences. Their customers go elsewhere, their employees find new jobs and their creditors take losses. Large financial firms are different. They borrow from and lend to many other institutions, hold deposits for households and businesses, and provide services that others rely on every day. If one of them stops paying its obligations, others may fail too, in a chain reaction.

Because of this, authorities may decide that letting a very large firm fail would cost society more than rescuing it. During the 2008 crisis, several governments chose to provide funding, guarantees or direct investment to major banks and insurers for this reason.

The moral hazard problem

Economists use the phrase moral hazard to describe a situation in which a party takes bigger risks because it does not bear the full cost of failure. If managers and creditors of a large bank believe the government will step in, they may lend more cheaply and take bigger gambles, since the downside appears to be covered. Critics argue that this creates an unfair advantage for the largest firms and encourages them to grow even bigger.

Arguments on the other side

Supporters of rescues point out that the alternative could have been a financial collapse affecting savings, jobs and credit for ordinary people. They also note that governments often received something in return, such as ownership stakes or interest payments, and that many rescue funds were eventually repaid. The question, then, is not simply whether to rescue, but how to do it fairly and how to avoid being forced into the choice again.

Ideas for reform

After the crisis, policymakers discussed several approaches:

• Requiring large institutions to hold more capital so that they can absorb their own losses.
• Creating legal procedures to wind down a failing financial firm in an orderly way.
• Making firms write “living wills”, plans showing how they could be broken up in a crisis.
• Limiting some of the riskiest activities of banks that take deposits.
• Improving the supervision of institutions whose failure could threaten the system.

Different countries adopted these ideas to different extents, and the debate continues.

Why a game can illustrate it

A block tower is a surprisingly good picture of the problem. Some blocks bear much more weight than others, and removing the wrong one can bring everything down. In Collapse!, players experience this by pulling blocks that represent real contributors to the crisis. The activity does not argue for one policy, but it makes clear why people worried so much about the structure as a whole. The home page explains how the game works.

For related background, see the timeline of the crisis and the guide to CDS and CDOs.