Too big to fail

I was interviewed, recently, for a school project on financial services. One of the questions concerned the reasons why, sometimes, a bank is described as ‘too big to fail’. Here is my take. Anything to add to help this Y12 student?

Question: Why was Bank [name of bank] described as ‘too big to fail’?

Financial services organisations do not create anything tangible; their value comes from bringing together lenders and borrowers. That means that the whole industry works on the basis of trust. Individual and institutional lenders hand their savings to the bank because they trust it to invest the money wisely on their behalf and generate some return for the lender.

banking

Lenders also trust that the bank will still exist and will return their money if and when they decide to withdraw their savings. This trust results from the expectation that banks work in good faith (e.g., are not careless with the lenders’ money) and have the expertise to screen good from bad investments.

If I think that the bank might fail – because it was reckless or incompetent – I will run to the bank to get my money back. That’s what happened with Northern Rock in 2007 (see here). If we all do this, there is no money for the bank to invest and the whole system collapses.

Governments are really keen to ensure that the system does not collapse as it is at the core of our modern way of life.

2 thoughts on “Too big to fail

  1. To help your student:
    The problem of too big to fail has to do with the moral hazard of fractional reserve banking. If bank deposits are not considered as such then those institutions misrepresent the trust of depositors. Bank runs are just a realization of this bank “fraud”, legalized by law.

    Legally, bank deposits actually aren’t “deposits”. They are considered liabilities and, as such, banks are allowed to use it freely (within the limits set by the Basel Accords):
    «The banking terms “deposit” and “withdrawal” tend to obscure the economic substance and legal essence of transactions in a deposit account. From a legal and financial accounting standpoint, the term “deposit” is used by the banking industry in financial statements to describe the liability owed by the bank to its depositor, and not the funds that the bank holds as a result of the deposit, which are shown as assets of the bank.»

    Also, recently I’ve read somewhere of an english court decision in the 18th/19th century(?) that establishes this legal precedent.

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