SHOULD BIG BANK BE BROKEN UP

TO PREVENT “TOO-BIG-TO-FAIL” PROBLEM

Prepared for

Lecturer: Dr Nguyen Thi Hoang Anh

Prepared by
K58CLC3
Dang Trieu Bao
Cao Huyen Dieu
Do Nguyen Duc Duy
Tran Hoang Ngoc Chau
Nguyen Pham Cong Minh
Nguyen Hoai Ninh Khang

March 6, 2021
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Abstract

In the steps of the era, the financial system has become an important part of the economy. But

the more essential it is, once there is a problem, the more drastic its impact on the country is.

It was not until the global financial crisis in 2008, when the term “too-big-to-fail” became a

common phrase, did people get aware of how serious this problem is.

This report analyzes information about the financial system as well as commercial banks and

provides an opinion on the need of the influential financial institution. Based on comparison

among developed countries with a strong financial system and events that have a significant

impact on the economy, the research shows the indispensable role of financial institutions,

particularly big banks, to the growth of a country’s economy.

However, benefits always come with risk. So, we hope to see the reform in regulation of the

government in order to minimize the situation.

Keywords: big banks, too big to fail, financial system, events, financial crisis.

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Introduction

As a key component of the financial system, banks allocate funds from savers to

borrowers in an efficient manner. They provide specialized financial services, which reduce

the cost of obtaining information about both savings and borrowing opportunities. These

financial services help to make the overall economy more efficient. So banks become a

crucial factor of almost all transactions. It not only helps in the promotion of both domestic

and foreign trade but also motivates the increase in production by enabling businessmen,

industrialists as well as governments to meet their credit requirements. Specifically, it holds

the most important position in monetary, payment and credit operations in the economy of

the entire population. In other words, banks are the "backbone" of the movement of the

economy.

But due to the rapid growth, a new problem arose. That is when certain corporations,

particularly financial institutions, grow so large that its failure threatens the integrity of the

financial system and of the national economy in which that system is embedded.

The bankruptcy of Lehman Brothers, one of the world’s largest banks in the 20’s,

makes this an opportune time for a reality check.

So should these banks be broken up into smaller ones to prevent the problem? Being

curious about the answer, we decided to choose this topic.

This paper aims to report the accumulated information about the pros and cons of

financial intermediaries. The answer to the topic above accompanied with some factors which

are believed to be the reasons is included.

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Findings

“Too-big-to-fail” event: The collapse of the Lehman Brothers.

The findings will be presented in four sections according to the following

characteristics: Summary of the economic crisis 2008, Government relief, The reason for

Lehman's downfall and Consequence of that event.

Summary of the economic crisis 2008

The US financial crisis originated from the Subprime credit, also known as high-risk

mortgage credit for the real estate market, and the loosening of monetary policy enforcement,

the "cheap USD" maintained for a long time by the U.S. administration, which has led to the

formation of financial and real estate "super bubbles". The development of many new

financial services and products in the field of banking and finance, transforming loans into

investment tools, leading to the triggering of a breakdown in the housing credit market, which

then spreads the line to the U.S. banking and financial system.

Government relief

Jp Morgan Chase and the Fed on March 16, 2008, bailed out Bear Stearns' massive

debts. These Fed interventions are considered by analysts to be "rare" in the organization's

history, showing the severity of the credit crisis facing America. But not stopping there, the

real financial seismicity erupted on September 7, 2008 when two giant American mortgage

lenders Freddie Mac and Fannie Mae were forced to be taken over by the Government to

avoid the risk of bankruptcy. Due to the financial crisis, America's number one investment

bank, Merrill Lynch was also acquired by Bank of America. The government has been forced

to pump $85 billion into the world's largest insurance group AIG to avoid a worse outcome

for the country's financial markets.

The reason for Lehman's downfall

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+ Given reason: Lehman did not have enough collateral, and the Fed therefore

could not legally provide them with loans.

+ Actual research shows that:

Lehman Brothers was at the height of the crisis with Merrill Lynch, Washington

Mutual and AIG. If all is saved, the Government will set a very bad precedent, encouraging

corporations to engage in more risky activities. The government wants the private sector to

understand that it is necessary to solve its own problems and that there needs to be some

sacrifice for the market to understand this.

Moreover, the close to the U.S. election was also sensitive as the financial crisis

became the subject of debate between the two Democratic and Republican presidential

candidates. The use of people's tax money to rescue financial corporations needs a very

convincing reason. Sacrifice at the moment is probably essential for the market and it is

necessary to choose to have the lowest cost to society.

Freddie Mac, Fannie Mae as two operating corporations are guaranteed by the

Government to provide real estate credit to the people, so these two corporations cannot die.

AIG is a big insurance corporation, providing millions of insurance contracts for people.

With a whopping $1 trillion in assets, AIG is probably not the choice. Instead, the

Government's best choice is to force the private sector to save Lehman himself or let Lehman

go bankrupt.

Consequence:

After Lehman Brothers declared bankruptcy in September 2008, approximately

twenty-six thousand of the firm’s employees worldwide lost their jobs, and investors suffered

immense losses, fueling the country’s greatest economic downturn since the crash of 1929.

On September 16, 2008, one day after Lehman’s collapse, the Federal Reserve Bank of New

York lent $85 billion to the global insurance company American International Group (AIG),

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whose assets failed to cover its mounting credit default swap contracts. As confidence in the

banks eroded, borrowing rates rose and home foreclosures continued to spike.

Lawrence McDonald, author and a former vice-president at Lehman Brothers, reflects

back on the devastating cost brought about by the collapse, recognizing that “every fraction

of every inch of those financial graphs represents hope or fear, confidence or dread, triumph

or ruin, celebration or sorrow.”

Discussion

As we have seen, if significant systemic improvements in the banking system are

required to prevent another recession, foster financial stability, and monitor moral hazard and

excessive risk-taking, we should all be in favor of making the changes. However, forcing

large companies to split up, say through the imposition of arbitrary limits on assets, does not

seem to be a smart way to accomplish those goals.

Therefore, the answer is no, we still need big banks in the economy due to the five

reasons following.

Reasons

1. Only large bank can handle

To begin with, having large companies in the financial sector, as in other sectors, has

both advantages and disadvantages. TBTF is undoubtedly a (major) issue, and there are other

issues correlated with scale, such as large corporations wielding excessive political clout.

Large financial companies, like other sectors, have cost advantages in certain areas and can

offer facilities that smaller firms cannot. The ability to leverage economies of scale (in

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technology, in building networks, in branding), greater risk diversification, the spreading of

fixed overhead costs over many operations, the ability to sell combinations of complementary

goods, and global scope are all potential advantages of size for banks (not synonymous with

TBTF status). Even if you ignore the short-term costs and disruptions that breaking up the

largest banks will likely cause, a US financial system without large companies would likely

be less competitive in the long run, delivering less services at a higher cost. From a national

standpoint, this approach could entail handing over leadership in the industry, as well as the

employment and income that come with it, to others.

2. The megabanks are the lifeblood of the economy.

The banking system has actively implemented the restructuring scheme associated

with bad debt settlement, thereby improving the efficiency of capital flows in the economy.

The central bank's credit solutions and policies are on the right track (the average credit

growth is 15% / year, in 2020 alone is estimated to increase by 11%, this is an appropriate

increase in the context of credit demand of the economy remains weak due to the impact of

the Covid pandemic 19, an example from Viet Nam).

In addition, the banking system also promotes the development of non-cash payments,

diversifies and improves the quality of payment products and services, implements security

solutions and secures the technology system, information, ensuring safe and effective

payment for businesses and people. Especially big banks create national reach all over the

world which is easier in capital mobilization and will also be able to control the cash flow

continuously. Reaching out the world activities clearly showed through the event that the

World Bank (WB) and the State Bank of Vietnam signed an Aid Agreement for a Covid-19

Vietnamese emergency response technical assistance project worth more than 6.2 million.

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3. Be the most efficient tool of government in social policies.

In the context of enterprises and people being severely affected by the Covid-19

epidemic, natural disasters, floods, and droughts, the State Bank has set the task of solving

difficulties for production and business activities. Right after the Covid-19 pandemic

happened, the State Bank issued Circular 01 allowing credit institutions to restructure their

repayment terms, exempt, reduce interest and allow the debt group to remain intact; payment

fee reduction. These are timely and very practical solutions for businesses and people, and are

strongly supported and implemented by credit institutions.

Agribank - Commercial Bank in Viet Nam with the largest credit implemented the

solutions under Circular 01 to 52,846 billion VND for customers, in which: Restructuring the

repayment term for 14,433 customers with outstanding debt of 43,478 billion VND.; Interest

exemption and reduction for 1,512 customers with outstanding balance of interest exemption

or reduction is 9,368 billion dong, interest amount is 16 billion dong. In addition, Agribank

provided new loans of nearly VND 60,000 billion to more than 18,000 passengers affected by

Covid-19; Lowering interest rates for more than 35,000 customers with the loan balance

lowered interest rates over 45,000 billion.

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4. Risk can be reduced through regulations of the government.

So, through years of development, the US government is constantly looking for

solutions to develop and strengthen the economy through the enactment of banks, and never

has a policy to cancel or break up the big bank.

For example, The Glass–Steagall Act of 1933, which was one of the most important

banking laws, was officially repealed in 1999. The repeal enabled depository banks to expand

their business operations. Senators John McCain and Elizabeth Warren proposed resurrecting

Glass-Steagall during the 2013 legislative session.

The leverage ratio for investment bank Goldman Sachs from 2003 to 2012, calculated

as debt divided by equity. The lower the percentage, the better the company's ability to

absorb losses.

In the aftermath of the subprime mortgage crisis that began in 2007, the United States

passed the Dodd–Frank Act in July 2010 to further improve financial system regulation. The

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Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd–Frank) mandates that

banks minimize their risk taking, by requiring greater financial cushions (i.e., lower leverage

ratios or higher capital ratios), among other steps.

In the event of financial distress at the bank or in the financial sector, banks must

maintain a ratio of high-quality, easily sold reserves. These are the financial needs.

Furthermore, regulators have collaborated with banks to reduce leverage levels following the

2008 financial crisis. The leverage ratio of investment bank Goldman Sachs, for example, has

dropped from 25.2 in 2007 to 11.4 in 2012, indicating a much-reduced risk profile.

The Dodd–Frank Act contains a version of the Volcker Rule, a measure to prohibit

commercial banks from engaging in proprietary trading. Proprietary trading is where a bank

uses customer deposits to invest in risky assets for the bank's advantage rather than the

customers'. In its current form, the Dodd–Frank Act contains many loopholes that facilitate

proprietary trading in some situations. However, the regulations required to enforce these

elements of the law were not implemented during 2013 and were under attack by bank

lobbying efforts. The Dodd-Frank Act will be repealed, according to US President Donald

Trump, Obama's successor. With 258 votes in favor and 159 votes against, the US House of

Representatives voted on May 22 to repeal much of this law's provisions. Previously, the

Senate passed the bill by a vote of 67 to 31 on March 14.

The Economic Growth Act, Regulatory Relief, and Consumer Protection is the latest

legislation. On May 24, President Trump signed the bill into law. Small banks, large-scale

custodian banks, and mortgage credit are all exempt from Dodd-Frank limitations under the

new legislation. credit bureaus and small-scale lenders.

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Conclusion

This essay included a thorough examination of the banking sector's problems. It is not

a new concept to believe that certain financial institutions are too big to fail. Neither is the

problem that such firms pose for policymakers. Critics claim that the policy is unsuccessful,

and that large banks and other institutions should be allowed to collapse if their risk

management is insufficient, following the global financial crisis of 2007–08. However, the

regulatory regime for large, complex financial institutions are undergoing a vast change from

that which prevailed before the financial crisis. The changes will bring both costs and

benefits. But one thing is certain: big banks should not be split up in order to address the

“too-big-to-fail” crisis. They will continuously exist and thrive for progress of the economy.

Furthermore, the potential for a large bank's failure to cause major damage to other

businesses or seriously hinder the functioning of the financial system, as well as the risks to

the wider economy, has made policymakers wary of allowing large banks to fail.

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References

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Fail Problem https://www.researchgate.net/publication/228139347_The_Dodd-

Frank_Act_A_Flawed_and_Inadequate_Response_to_the_Too-Big-to-Fail_Problem

Ben, (2016). Ending “too big to fail”: What’s the right approach?

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Christian, (2016). 7 Reasons Why Breaking Up Big Banks Is a Bad Idea

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Peter, (2012) Breaking Up the Big Banks: Is Anybody Thinking?

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