Academic journal article Journal of Regional Analysis & Policy

An Analysis of Resolving Too-Big-to-Fail Banks throughout the United States

Academic journal article Journal of Regional Analysis & Policy

An Analysis of Resolving Too-Big-to-Fail Banks throughout the United States

Article excerpt

1. Introduction

Banks have failed in all of the regions of the country throughout US history. The worst years for such failures were during the Great Depression: roughly 9,000 of about 25,000 banks failed, with nearly half of the failures occurring in 1933 alone. Depositors everywhere became concerned that their banks were on the verge of insolvency, and they rushed to withdraw their funds. This forced banks to sell offtheir assets at fire sale prices, thereby turn-ing illiquidity problems into insolvency problems throughout the banking industry. The result was a major disruption in the payments system and a se-vere tightening of available credit, with a devastat-ing impact on economic activity in all regions of the country.

To prevent future bank runs by depositors, the Federal Deposit Insurance Corporation (FDIC) was established in June 1933. The FDIC guarantees de-posits, up to a limit, to lessen depositors' incentive to make panicked withdrawals and thereby to re-duce the likelihood of bank runs. The FDIC is also assigned the task of resolving banks that fail. It is to do so in the least costly manner, which historically has involved liquidating a failed bank and paying offinsured depositors or else arranging for a health-ier bank to acquire a failed bank.

Based upon these two methods of resolving troubled institutions, there was to be no differential treatment between big and small banks.1 In 1950, however, the FDIC became concerned that a bank might be confronted with a temporary funding problem, so it sought and received authorization to infuse funds into such a bank to keep it open. The stipulation was that it could provide "open bank assistance" only if such a bank was essential to providing adequate banking services to a communi-ty (FDIC, 1984), which was likely to be the case only for a big bank. In this type of situation, the FDIC could ignore the requirement to choose the least costly resolution method.

The issue of size became important in 1984, when the government bailed out Continental Illinois Na-tional Bank & Trust ("Continental"), the seventh largest bank at the time. This bailout occurred be-cause of concerns about systemic risk, due to the bank's size, which could affect other banks in all parts of the country. The FDIC infused $1 billion in new capital into the Continental Illinois Corpora-tion, the bank's holding company, in exchange for preferred stock convertible to 80 percent of the equi-ty. These funds were then down-streamed to Conti-nental as equity capital to recapitalize the bank. When the government bailed out Continental, Stew-art B. McKinney, a Connecticut congressman, de-clared that the government had created a new class of banks, those too big to fail (TBTF).2 Ever since this bailout, there has been a belief that certain banks or bank holding companies are TBTF, which we call the "TBTF problem."

This belief that some banks are TBTF was behind the regulatory response to the financial crisis of 2007-2009, when the government bailed out the big-gest banks headquartered in various regions of the country. Many individuals consider the biggest banks to have largely caused the crisis, and this be-lief has focused far greater attention on the TBTF problem. Indeed, the Dodd-Frank Wall Street Re-form and Consumer Protection Act ("Dodd-Frank") of July 2010 created a new federal receivership pro-cess pursuant to which the FDIC may serve as the receiver for big banks whose failure poses a signifi-cant risk to the financial stability of the United States. The FDIC's new authority is intended to eliminate the TBTF problem once and for all.

This paper looks at the historical treatment of troubled banks throughout the country by the FDIC. It examines how the FDIC resolves troubled banks and the sources of funds available to it in the event resolutions are costly. This examination focuses on the treatment of big versus small troubled banks to assess the importance of the TBTF issue. …

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