Nirali Shah

Finance 320-601
Professor Bateman
Analysis of “Too Big To Fail and Living Wills”

In recent political news about Wall Street Senator Bernie Sanders stated his
view that “If a bank is too big to fail, it is too big to exist”. He supported his belief by stating,
“The 6 largest financial institutions in this country today hold assets equal to about 60% of the
nation’s gross domestic product. These 6 banks issue more than two-thirds of all credit cards
and over 35% of all mortgages. They control 95% of all derivatives and hold more than 40%
of all bank deposits in the U.S…They received a $700 billion-dollar bailout from the U.S.
taxpayer, and $16 trillion in zero interest loans from the Federal Reserve. Despite that,
financial institutions made over $152 billion in profit in 2014”. This just puts into perspective
how large these institutions are. But before I get into the specifics, let me explain what “Too
big to fail” means and where it originated from.
A firm that is “too big to fail” is a firm that is so essential to the country’s economy
that the country’s government must make sure that the company(s) must never go bankrupt or
halt trading. The reason they must prevent these companies from going bankrupt is because if
any one or more of these companies do, it will create a ripple effect in the economy. If one of
them goes bankrupt, the smaller companies that are dependent on them for resources and
income will fall down as well. This will create a high unemployment rate as the number of
jobs available decrease and therefore lead to less consumer spending. This will cause an
overall fall of the market and lead into another recession.
We faced this situation on September 15th, 2008 when Lehman Brothers filed for
bankruptcy. The financial district at this point wasn’t concerned as much because they thought
the government would step up and save the bondholders from suffering huge losses like they
had previously done with Bear Stearns as they negotiated the purchase of Bear Stearns to J.P.
Morgan. Over the years, they had seen that when a large financial institution had filed for
bankruptcy, the government came to the rescue and bailed them out. This happened with Bear
Stearns, Continental Illinois, Long Term Capital Management, Fannie Mae, and Freddie Mac.
This created the illusion in the mind of the public that if they lended money to a big bank it is
like lending money to the U.S. Treasury but with higher interest so there were a lot more
international investors. However, what set off the 2008 panic was that this didn’t happen with
the Lehman Brothers. Instead the Dow Jones fell by 4.4% as the global financial markets froze
up. As a result, banks stopped lending money to the public because they didn’t know which
financial institution would fall bankrupt next. They weren’t sure who would pay them their
money back so they issued a credit/cash market freeze. This affected so many businesses that
were dependent on this market as they weren’t sure if they could pay their workers now.
When this issue rose, the financial industry asked the government once again for help and the
government saved AIG. The government decided to use the Troubled Asset Relief Program to
put $700 billion dollars worth of taxpayers’ cash into banks and financial institutions. By
doing so, the government indirectly encouraged these institutions to take on more risks than
necessary since any failures will be covered by the government at a cost of the taxpayers’
funds. This problem is referred to as the Moral Hazard Problem. As a result, we are now faced
with the controversy today of whether government should bail out big banks and if they
should use tax payers money to do so.
While there are many large institutions that are “too big too fail”, the 4 largest banking
institutions are J.P. Morgan Chase, Bank of America, Citigroup, and Wells Fargo. Together
these firms employ about 1.15 million Americans. Here is the breakdown of the big four:
 J.P Morgan Chase:
o Total Assets: $2,351,698,000
o Market Share: 16.52%
 Bank of America
o Total Assets: $2,144,316,000
o Market Share: 13.88%
 Citigroup
o Total Assets: $1,731,210,000
o Market Share: 12.31%
 Wells Fargo
o Total Assets: $1,787,632,000
o Market Share: 10.70%

From the following information that I found off of Yahoo Finance and CNBC, we can
see that even though there are many banks, these 4 banks combined own 53.41% of the market
share of the banking industry and have a combined asset total worth $8,014,856,000! We see
that investments are highly concentrated in these 4 big banks, as they take up more than 50%
of the investments available in the market from global investors. Through various mergers and
acquisitions, the top 10 large U.S. banks in the banking industry now hold more than 50% of
U.S. deposits. This large increase in investing in these four companies specifically is due to the
belief that bondholders will get higher investment returns by investing their money into big
banks and the belief that the government will be there to catch their fall by bailing these too
big to fail banks out.
We have a split view between those who think firms that are “too big to fail”
provide more risks and problems while others who think that it benefits us more. Some risks
or problems generated from having big financial institutions are that it creates a moral hazard
problem. Ben Bernake stated in his conversation with the Federal Reserve Board, “If creditors
believe that an institution will not be allowed to fail, they will not demand as much
compensation for risks as they otherwise would, thus weakening market discipline; nor will
they invest as many resources in monitoring the firm's risk-taking. As a result, too-big-to-fail
firms will tend to take more risk than desirable, in the expectation that they will receive
assistance if their bets go bad.” This increase in risk increases the possibility of a financial
crisis and the after-math effects to be much worse than anticipated. The government needs to
simply stop “guaranteeing” these “too big to fail firms” that they will be there to bail out these
firms if they declare bankruptcy or fall in any sort of way.
Another cost of too-big-to- fail that Bernake states in his testimony is that it
creates an uneven playing field between big and small firms. What he means by this is the
other banks that are not big financial institutions have no chance at competing with them. Just
in the previous big 4-bank analysis, we learned that the 4 banks when combined take over 50%
of the market share meaning more than 50% of investors invest a large portion of funds into
those banks specifically. So the other 20+ banks that share the other 50% of the market share
don’t get nearly as many investments as the big financial institution banks get. This increase in
investment in big banks raises the market share big banks have. This increases overall risk of
economic efficiency and financial stability the market would have if any of these big banks
were to declare bankruptcy. This would lead to another risk as we wouldn’t be sure what
resolutions to take to keep our markets financially stable if a big bank fell in the economy. Due
to the uneven playing field, if smaller firms fail, even though it would be a concern in the
economy, the effects on financial stability it would have wouldn’t be nearly as drastic as if a
big firm failed like what we saw with the Lehman Brothers in 2008/2009.
However, even though there are many problems and risks with too big to fail
firms, there are some benefits from having such firms. The biggest advantage of having too big
to fail firms is the fact that these firms are so big. Due to their stature as a large corporation,
they are expanding their services not only nationally in the U.S. but also internationally. This
brings in many more investors than smaller firms can get. The more investors, the more money
that is brought into the economy, this allows them to provide more services, provide more jobs
to people seeking jobs. For example, in 2015, according to the St. Louis Federal Reserve big
banks are critical for job creation in the economy. They provided 40% of all small business
loans, 85% of all consumer credit, and 70% of all mortgages. Together they serve more than
70 million U.S. households, 85,000 small businesses, and more than 1,000 large corporate
customers. These firms also are able to provide services for cheaper rates compared to smaller
firms due to the amount of investors they have in their company as well as customers.
According to the St. Louis Federal Reserve, big banks have an advantage over smaller banks
as they can “lower the risk premiums demanded by creditors of large banks”. Overall the
impact big banks have on the
economy can be best summed up by
the following graphic:

By being a large bank, it can
give out credit to small banks, which
give them to small businesses to
create more jobs. It can also led out
more loans to large businesses that
have contracts with small businesses.
Overall, it pushes for a positive
impact and positive economic growth
as more people have jobs and
therefore spend money on consumer products. Thus, making the economy run.
Due to the split view of whether or not we should keep or break big financial
institutions, the government has made it mandatory with the Dodd-Frank Act for all “too big to
fail” firms to make a Resolution Plan or Living Will. According to Bloomberg Business Week,
living wills “are the most straightforward manifestation of the regulators post-crisis efforts to
make sure that no bank is too big to fail anymore”. Therefore, it is a requirement of each bank
to file a plan explaining how it will recover from a hypothetical bankruptcy such that it will
cause minimum disruption of the financial system. The government wants to prevent another
2008 type of economic effect from using taxpayers’ money to bail out these institutions in
order to keep the economy afloat. However, currently the problem we face is that no bank has
created a good enough resolution plan.
When looking at big bank resolution plans, FDIC Vice Chairman Hoeing, “No firm
shows itself capable of being resolved in an orderly fashion through bankruptcy. Thus, the
goal to end too big to fail and protect the American taxpayer by ending bailouts remains just
that: only a goal”. The banks that failed to make a sufficient resolution plan include Bank of
America, JP Morgan Chase, Bank of New York Mellon Corp., State Street Corp., and Wells
Fargo. They have until October 1, 2016 to make a proper resolution plan otherwise regulators
may decide to take actions like restricting the bank growth in the economy and requiring them
to keep more money as part of the reserve requirement so they will have that money to cushion
their fall in they failed. One reason why banks are having such a hard problem making a
resolution plan is because of the uncertainty of the future. Firms have a hard-enough predicting
what their financials will look like a year in advance, so they are having a hard time finding a
medium of understanding from the regulators who want them to predict and make a plan of
recovery if their firm ever did declare bankruptcy. For those that do make a resolution plan
that meets the terms of the regulators, it leaves people to wonder how the banks will truly
carry forward their decisions if they ever did go into bankruptcy. Some believe it could be ugly
if the financials predicted are completely off from what they actually face, while others look to
the resolution plan as a list that suggests what steps the firms should take in an impending
The regulators did respond with how to fix each banks Living Wills as the ones that
were presented had unrealistic assumptions on how bank executives thought their customers,
investors, and regulators would act if they did declare bankruptcy. The banks also didn’t
clearly identify what structural changes they would make for their firm to become a smaller
entity. For example, Bloomberg Business reports, “In the letter to Bank of was
instructed to fix its process for estimating how much liquidity would be needed to make sure
subsidiaries could keep going after a failure”. Wells Fargo was faulted for material errors,
while State Street Bank of New York Mellon needed to clarify their business lines and legal
entities to improve their ability to be resolved. The FDIC expanded on more shortcomings of
the Living Wills that were submitted. Such shortcomings they wrote that needed to be more
specific were, “establishing a rational and less complex legal structure that would take into
account the best alignment of legal entities and business lines, developing a holding company
structure that supports resolvability, amending qualified financial contracts to address the risk
of counterparty actions, demonstrating that shared services would continue throughout the
resolution process, demonstrating that operational capabilities which are necessary for
resolution purposes would be put in place, and placed an emphasis on transparency on firm
resolvability to the public”. In addition to these, one area that needed emphasis was the
concept of derivatives. Derivatives make bankruptcy situations complicated because even if
the banks collapse, the banks are required to make payments to derivative holders before the
other creditors and clients that have invested in their company. The regulators want a concrete
plan given to them that tells them how each bank will approach all the issues that either failed
to be mentioned or weren’t specific enough.
I believe the Living Wills help in the sense that they make the firms think through their
points of vulnerability and organizational structure at the current point in time and what they
may face if they ever declared bankruptcy. However, they are not really reducing the risk of
banks being too big to fail. Regulators are merely telling them areas in which these firms need
to improve in their preparedness plan if bankruptcy happens. By implementing Living Wills, I
do agree that it makes them catch areas they may have overlooked and therefore can fix the
error before it causes bankruptcy. If banks fail to make a plan according to the regulators
requirements, then they face consequences and the regulators get to decide how they want to
fix these big firms. However, bankruptcy is something that you can’t really prepare for. The
plan that they make would be nullified on that day because they will make decisions according
to what they think is necessary to do in that specific scenario. There could be other factors that
lead to different decisions that weren’t anticipated when making the Living Will years ago.
While it does provide an outline of what to do when bankruptcy happens, I believe it it’s very
hard for a company to follow what they wrote on that Living Will years back word-for-word.
Therefore, it doesn’t actually reduce the risk of banks being too big to fail. It merely focuses
on how to prevent the firms “failure” aspect without doing anything to change the vast size of
the firms.