Literature Review

The failure of a single financial institution has the potential to spark catastrophic losses in local, regional and global financial systems. The global financial crisis of 2008 has proved this. Financial institutions considered “too big to fail” (TBTF) have always been of concern to policy makers. However, this was highlighted especially during the global financial crisis, with the collapse of several large financial institutions. If a bank has a large role in a nation’s financial system, for instance by processing many of the nation’s payments or security transactions– its failure may threaten the solvency of other institutions financially connected to it and to each other. By creating a domino effect, the failure of a TBTF bank threatens to cripple the national economy. Should an important bank fail, and other banks rely upon this bank and its creditors to fulfil their obligations to operate, then these banks too, and potentially those institutions they are financially connected to, may collapse as well. If the spill-over effects generated via this process are large enough, then the failure of a big bank could trigger an economy-wide recession. ^iv

Large financial institutions that failed or required a government “bailout” included firms such as Citigroup, Fannie Mae and Freddie Mac, AIG, Bear Stearns and Lehman Brothers, which were either depositories, insurance companies, government sponsored enterprises or investment banks. Similarly the European debt crises has shown how the interconnectedness of large financial institutions may have a rippling effect on the rest of the banking system.

“Too big to fail” has raised a lot of issues due to the systemic risk these large firms carry with them. There are many definitions for “systemic risk” and may be used in different contexts. For instance, Acharya et al. (2009) ^xvi define systemic risk as “the risk of a crisis in the financial sector and its spill over to the economy”. De Bandt and Hartmann (2000)^xv define systemic risk as “the risk of experiencing an event such that the release of bad information on, or failure of, one institution propagates across the system resulting in further failures of other institutions” ⁱⁱⁱ. Thus we can say that Systemically Important Financial Institutions (SIFI’s) are firms that would have grown to significant proportions, even outgrowing their economies of scale. They also hold a high leverage, focus on short term funding, and have a high proportion of trading in complex structured products in an interconnected market.[i]