What Does It Mean To Be Too Big To Fail?

Posted on Wednesday, April 26, 2023 by Lydia SinclairNo comments

In the world of accounting and finance, there are two complex, interlinked and often contradictory concepts that people entering forensic accounting jobs are often obligated to navigate in the wake of a major financial event.

In the wake of the collapse of Silicon Valley Bank in March 2023, the biggest banking collapse since 2008, a lot of discussions have returned to a dilemma at the heart of the banking system.

SVB, along with other major banks that have failed, is considered officially to be a systematically important financial institution, often known colloquially as “too big to fail”.

These are institutions that, if they were to collapse without any form of safeguarding or protection, would cause major issues for the wider economy and cause a run not only on the bank that is failing but other banks that are believed to have a connection to it, in an accounting concept known as contagion.

However, by bailing out large institutions, a potentially larger issue is created in the form of increasing the risk of moral hazard.

A moral hazard is any situation where one party in a contract feels incentivised in taking risks because they will not face the full consequences of such a risk.

If a bank knows that they will not have to face the consequences of their risks, the moral hazard theory postulates that they will take greater risks to maximise profitability, something pejoratively described as “privatised profits, socialised losses” due to how bailouts are typically funded by taxpayers

Essentially a “too big to fail” institution cannot be allowed to collapse, because it leaves depositors effectively out of pocket, but at the same time saving them has consequences on future behaviour.

Solving this dilemma is difficult, and the main options suggested include breaking up any financial institution that would be too big to fail, and a common protest slogan was “too big to fail is too big to allow, heavily regulating and monitoring large institutions or more heavily taxing institutions that size.

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