top of page
  • Shuchi Agrawal and Isha Ahlawat

Reigning in “too-big-to-fail” – Toward Incentive-Based Regulation


Shuchi Agrawal and Isha Ahlawat *


 

I. INTRODUCTION


A healthy financial system is the crucible in which economic growth and prosperity are forged. Institutions within the financial system perform several crucial functions such as facilitating payments, mobilizing household savings to fund economic activity, monitoring the performance of borrowers, and managing risk. The financial system is also extremely fragile, and the failure of financial institutions takes a heavy toll on the economy, engendering credit crunches, economic instability, or market crashes. The ill effects are amplified if the institution is Too Big To Fail (“TBTF”) – an organization so large and interconnected with other entities in the financial system that its downfall might trigger widespread market collapse and economic downturn


As of 2023, the Reserve Bank of India (“RBI”) has recognized three banks as TBTF and subjected them to heightened regulatory norms. Termed as Domestically-Systemically Important Banks (“D-SIBs”), these are the State Bank of India (“SBI”), ICICI Bank, and HDFC Bank. While the TBTF doctrine has been employed numerous times by governments all over the world to bail out bankrupt organizations, this article argues that the time has come to consider other regulatory approaches. During the financial crisis of 2007-08, the TBTF doctrine was criticized for being counter-productive and incentivizing big companies to make riskier decisions, with the assurance of a government bailout.


Nowhere is this truer than in India where just half a dozen industrialists collectively owe close to Rs. 3.5 lakh crores to banks, while the total capital of the banking industry is about Rs. 5 lakh crores. Should these businesses go bankrupt, seventy percent of India’s banking capital will disappear. This is what prompted a financial commentator to remark, “They are too big to fail. So, they have no worries really, as the system sustains them.”


In the following sections, we will explore whether size-based regulation offers any feasible solutions for securing the health of financial systems, or if it needs to be supplemented or entirely replaced by other ex-ante measures. The latter approach is favoured and an incentive-based regulation model to counter the risks posed by TBTF organizations is discussed.


II. THE TBTF DOCTRINE – AN OVERVIEW


For an institution to be considered as TBTF, it must have a high level of interconnectedness in the financial system in addition to having considerably high asset value. The ‘big’ aspect of TBTF does not refer solely to the size of the organization but to its overall footprint or importance to a community. In 1971, for example, Unity Bank, a relatively small and primarily Black institution in Boston was bailed out over fears that its failure would cause riots in Black neighborhoods. However, the size of an organization is an important consideration while assessing its footprint. It has been discovered that as banks become larger and highly complex, they also become riskier simultaneously. There is thus an established correlation between the size of a corporation and the threat it poses to the stability of financial systems.


On the face of it, the TBTF doctrine is concerned with preventing systemic problems that can arise when a large uninsured bank fails and leaves its depositors and creditors vulnerable.  It is feared that if the depositors and creditors of a failing institution withdraw their money, it can exacerbate the problems of the failing bank. Moreover, as the position of the collapsing bank worsens, it may struggle to keep its commitments to other financial institutions which might result in several otherwise healthy banks facing a liquidity crisis. This limited liquidity in the financial industry can precipitate the overall slowdown of economic activity. In the case of large international organizations, the economic damage can spill over across borders and create a global financial crisis.


Despite its merits, the policy of bailing out TBTF entities has come under fire for causing counterintuitive effects and being detrimental to the health of the financial system overall. This is because the TBTF doctrine creates a government guarantee which generates incentives for excessive risk-taking and imprudent debt financing. TBTF organizations operate with the implicit understanding that if their risks do not fructify, the government will rescue them because of their importance within the financial industry. In 2014, a study conducted on 224 banks found that the participating banks had issued higher levels of impaired loans after receiving increased governmental support.


The TBTF doctrine has also been accused of disturbing competition in the market as smaller firms do not get a similar level of protection against failure.  At the time of the 2007-08 financial crisis, the U.S. government had to pick and choose the organizations that it wished to save over the others. For example, AIG was offered a bailout package in the same week that Lehman Brothers was allowed to shut operations. This disparate treatment was justified by the fear that the downfall of AIG would be cataclysmic because AIG had provided insurance coverage of over half a trillion USD to numerous financial institutions in the U.S. and Europe.


On the other hand, Lehman Brothers at its peak had a market capitalization equal to a quarter of the market capitalization of AIG at its peak. In addition to this, depositors also tend to do business with larger banks compared to their regional counterparts due to their reputation of being safer. Once a bank achieves the status of TBTF it also tends to face lesser scrutiny from market participants and can raise cheaper and bigger debts.


Notably, the recent failure of Silicon Valley Bank and Signature Bank, precipitated by unprecedented bank runs, has put into spotlight the governance of TBTF organizations and raised interesting questions regarding their regulation. The failure of both banks was among the largest in U.S. banking history after the collapse of Washington Mutual in 2008, even though the banking industry in the U.S. has been setting records of excessive reserves. The instances of the failures of both banks bear testimony to the fact that despite the measures taken after the 2008-09 financial crisis, our economies are not immune to disruptions from bank failures.


III. EFFCTIVENESS OF SIZE-BASED REGULATION


As a consequence of the numerous problems associated with TBTF firms, it has been repeatedly argued that large corporations should not be allowed to exist and must be deliberately broken up into smaller units. It has been claimed that systemic cascades in the economic ecosystem occur because of an unpredictable interplay of different parts of the financial sector, and it is difficult to assess the kind of impact the failure of a part of the system will have on another indirectly linked part. This is because risk managers can only reasonably determine the risk exposure of their institution and often do not account for external exigencies.


For instance, the financial crisis of 2007-08 was triggered by the collapse of several big financial companies, such as Lehman Brothers, AIG, and Bear Stearns. While these organizations could have foreseen their own downfall based on their risk exposure, it would have been much more onerous for another corporation to estimate the impact of these organizations’ downfall on its operations. Apart from this, it has also been found that larger banks tend to leverage more than smaller banks, even when the bailout policies treat them symmetrically because larger banks internalize that their decisions affect the bailout policies.


However, at the same time, there are some advantages to having large organizations within the financial sector. Larger firms can be cost-effective and provide services that smaller firms cannot offer. TBTF companies can use economies of scale and better diversify their risks as well as serve an international market. Further, a cap on the size of organizations would inhibit innovation. It would also be difficult to determine this cut-off cap size while accounting for economies of scale, synergies, and so on.


Externally imposed limits on the sizes of financial institutions may not serve their intended purpose and may lead to a weaker economy. Therefore, instead of using a ‘one size fits all’ approach, centered on a command-and-control model, regulators must consider opting for an incentive-based approach that requires firms to determine their size by balancing the costs imposed on them and the synergies they utilize. Larger corporations must face regulatory burdens, such as surcharges, that are commensurate with the social, economic, and political risks they pose. If the costs accompanying their size outweigh the benefits, the firms will themselves be encouraged to reduce their sizes.


IV. ENVISIONING AN INCENTIVE-BASED APPROACH


In 2010, the Switzerland-based Financial Stability Board (“FSB”) made recommendations urging all member countries to develop frameworks to reduce risks attributable to Systemically Important Financial Institutions (“SIFIs”) in their jurisdictions. The Basel Committee on Banking Supervision (“BCBS”) came out with a framework in November 2011 for identifying the Global Systemically Important Banks (“G-SIBs”) and required all member countries to have a regulatory framework to deal with D-SIBs.


In India, RBI’s policy on TBTFs builds upon the BCBS method for spotting G-SIBs, adjusted to include how important a bank is domestically. The evaluation method of identifying D-SIBs uses indicators like size, interconnectedness, substitutability, and complexity of a bank. These factors are utilized to assign a score to each bank, and the banks are then divided into four groups and must have additional Common Equity Tier 1 capital requirements, ranging from 0.20% to 0.80% of risky assets, based on their group. Thus, as opposed to other banks, D-SIBs are subjected to more supervision, tailored to the risks they introduce to the financial system.

While the G-SIB/D-SIB framework is a welcome step towards reigning in TBTF organizations, it is not without its limitations.


Firstly, since it adopts a one-size-fits-all approach, it is not adequate enough to capture the nuances and complexities of different banks' risk profiles. Secondly, the heavy reliance on metrics such as size, interconnectedness, complexity, and substitutability might exacerbate pro-cyclicality by encouraging banks to take excessive risks during economic booms and reduce lending during downturns. Finally, reports have shown that banks have been engaging in regulatory arbitrage through year-end window dressing activity to lower their G-SIB scores, highlighting how the regulation can be cheated. Notably, 8 U.S. G-SIBs have been repeatedly found to lower their capital surcharges by lowering their systemic risk score gauged through the BCBS methodology.


This is largely done by reducing the notional value of over-the-counter derivatives (“OTC Derivatives”) in the fourth quarter of every year. The value of OTC Derivatives is important for computing the level of complexity, an indicator for determining the risk score for the G-SIBs. The U.S. Federal Reserve recently published a research note highlighting how G-SIBs reduce the value of their OTC Derivatives to lowball their risk scores and circumvent the requirements of capital surcharges. 


This leads to the inquiry – are we asking the wrong questions? Instead of asking “how” should we govern large financial institutions, perhaps we should ask whether such organisations should be allowed to exist in the first place or whether there should be punitive regulation that disincentivises growth beyond a certain level. Jeremy Stein, when he was the Governor of the U.S. Federal Reserve, had proposed a price-based regulation as opposed to a size-based regulation to mitigate the unfavorable effects of the TBTF Doctrine.


As per this recommendation, a surcharge would be imposed on banks which would vary with the size of the bank. Therefore, bank managers would have to decide whether to reduce or increase the bank size according to their understanding of the synergies involved in their operations.


The implementation of a progressive “Pigouvian tax” can perhaps also remedy the situation. Such a tax would help mitigate the systemic risks posed by large financial institutions, as the value of such a tax would vary based on the size, risk, and leverage of the concerned bank. Such a tax could also motivate the concerned firms to decrease their size or split up into smaller units to distribute their profits across different organizations. Moreover, the fragmentation of institutions could mitigate the risk exposure of organizations.


To illustrate, a bank might opt to segregate its operations, permitting one entity to focus on commercial banking and another to provide investment services. In this structured arrangement, the risks associated with each venture would be compartmentalized, enabling them to function autonomously. Consequently, if one of the ventures experiences losses, the other segment of the business would remain insulated from the impact. This approach would effectively diminish the overarching economic threat posed by TBTF organizations.


The funds collected from a Pigouvian tax can also be employed for various purposes such as enhancing financial literacy through public education programs or monitoring large financial institutions and the health of their assets. Further, in such a situation, the firms will not be able to pass on the entire tax burden to their customers as their smaller competitor firms will have to pay a smaller tax and will only pass on that smaller tax to their consumers. Hence, as discussed previously, to remain competitive, the TBTF organizations will have to either reduce their size or absorb the entire cost imposed on them.


The approach outlined above is not without its challenges. Firstly, it is difficult to determine an exact tax rate that accounts for a bank’s size, risk, and leverage without stifling economic growth or innovation. Banks may also avoid the tax by reorganising their businesses in a manner that does lip service to the regulation but does not actually reduce systemic risk. From a competition law perspective, a Pigouvian tax could also inadvertently create barriers to entry for smaller players by solidifying the market position of large banks that can afford the tax.


However, we must reckon with the fact that some financial institutions are too large and complex for the common good. Due to the immense wealth they hold and their deep-rooted connections with the economy, the existence of such banks significantly influences both economic and social outcomes, reinforcing power asymmetries within society. The challenge of regulating TBTF institutions is therefore not only technical but also political and must grapple with the forces that enable their outsized influence. The achievement of such an ideal can only occur through systemic change that redistributes power and wealth and democratizes the economy.


V. CONCLUSION


With increasing interconnectedness within the financial sector and the rise of a globalized economy, many more TBTF institutions will likely continue to rise in the future. This phenomenon presents numerous opportunities. These behemoth firms will have the capital, resources, and international presence to revolutionize our economies. They will be able to develop and launch novel financial products, offer competitive services, and benefit consumers. However, the rise of such corporations will also aggravate the downside that their collapse can have on our lives. Due to this, it is imperative to design and implement effective regulations governing TBTFs.


As there is a direct correlation between the size and complexity of financial corporations, the government should concentrate on restricting the sizes of large corporations. However, the most efficient size for any corporation depends on several factors, including its business model, the consumer base, leverage, and so on. Therefore, this ideal size would vary and would be different for different organizations.


In such a situation, the most optimal approach would be to create incentives and motivate each firm to comply with the general policy of size reduction proposed by the government. The recommendations made in this paper suggest the imposition of additional costs on large organizations based on their size, leverage, and profits to counterbalance the threat that their failure poses. This will encourage corporations to conduct a cost-benefit analysis and determine if the costs imposed on them outweigh the advantages they gain through their sheer size. If the costs exceed the benefits, the institutions will correct themselves and return to a manageable and stable size. The TBTF doctrine provides large organizations with a safety net and allows them to make reckless financial decisions. It is time to shift the burden of responsibility back to the TBTF corporations by putting them in charge of their well-being. If they choose to retain their size, they must pay the costs.


*Shuchi Agrawal is a Research Fellow at Vidhi Centre for Legal Policy (Corporate Law and Financial Regulation) and Isha Ahlawat is a BCL candidate at Oxford University.

 

 

Recent Posts

See All

Comments


bottom of page