Too Big to Fail

Business / By / September 6, 2023

“Too Big to Fail” describes financial giants whose collapse could harm the economy. Key features encompass systemic significance and moral risk. It sparks debates on fairness. Implications involve government support and market disparities. Policies like Dodd-Frank aim to address it. Instances include the 2008 crisis and the LTCM rescue.

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Characteristics

  • Systemic Importance: These institutions are considered systemically important due to their size, complexity, and interconnectivity.
  • Moral Hazard: The belief that these institutions will be bailed out by the government can lead to risky behavior, knowing they won’t face the full consequences of their actions.
  • Controversy: The concept of ‘Too Big to Fail’ is controversial, as it raises questions of fairness and market distortions.

Implications

  • Government Intervention: Governments may step in to prevent the collapse of these institutions to safeguard the financial system.
  • Market Distortions: It can create an uneven playing field, as smaller institutions may not receive the same level of support.
  • Economic Stability: Preventing the failure of these institutions aims to maintain economic stability and prevent a domino effect of financial crises.

Controversies

  • Moral Hazard Debate: Critics argue that ‘Too Big to Fail’ can encourage reckless behavior among large institutions.
  • Fairness and Equity: It raises questions about whether it’s fair for some entities to receive government bailouts while others don’t.

Policy Responses

  • Dodd-Frank Act: The U.S. implemented the Dodd-Frank Act to address ‘Too Big to Fail’ by introducing regulatory measures and a resolution framework for failing institutions.
  • Increased Oversight: Regulators have increased oversight and stress tests to ensure large institutions are better prepared for economic shocks.

Examples

  • 2008 Financial Crisis: The bailout of major banks during the financial crisis exemplified the ‘Too Big to Fail’ concept.
  • Long-Term Capital Management: The rescue of LTCM in 1998 showcased the risks associated with systemic institutions.

Key Highlights

  • Systemic Importance: Institutions classified as “too big to fail” are considered so vital to the stability of the financial system that their failure could lead to a catastrophic domino effect.
  • Moral Hazard: The perception that these institutions will be rescued by the government can encourage them to take excessive risks, knowing that they won’t bear the full consequences of their actions.
  • Government Bailouts: In times of crisis, governments may intervene to prevent the collapse of these institutions, often providing financial support or bailouts.
  • Market Distortions: The belief in government support can distort market incentives, as investors and institutions may engage in riskier behavior based on the assumption of a safety net.
  • Economic Stability: Preventing the failure of these institutions is seen as crucial to maintaining overall economic stability and preventing a financial meltdown.
  • Controversy: There’s ongoing debate about the fairness and moral hazard associated with bailing out large institutions while smaller entities may not receive similar support.
  • Regulatory Response: To address the issue, governments have implemented regulatory reforms, such as the Dodd-Frank Act in the U.S., to impose stricter regulations on large financial institutions.
  • Financial Crises: The concept gained prominence during the 2008 financial crisis when several major banks faced potential collapse.
  • Historical Precedents: Instances like the bailout of Long-Term Capital Management (LTCM) in 1998 serve as earlier examples of addressing risks associated with large financial institutions.
  • Global Implications: The failure of globally significant institutions can have far-reaching effects on international financial markets and the global economy.

Connected Financial Concepts

Circle of Competence

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The circle of competence describes a person’s natural competence in an area that matches their skills and abilities. Beyond this imaginary circle are skills and abilities that a person is naturally less competent at. The concept was popularised by Warren Buffett, who argued that investors should only invest in companies they know and understand. However, the circle of competence applies to any topic and indeed any individual.

What is a Moat

moat
Economic or market moats represent the long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.

Buffet Indicator

buffet-indicator
The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet’s favorite measures as a warning that financial markets might be overvalued and riskier.

Venture Capital

venture-capital
Venture capital is a form of investing skewed toward high-risk bets, that are likely to fail. Therefore venture capitalists look for higher returns. Indeed, venture capital is based on the power law, or the law for which a small number of bets will pay off big time for the larger numbers of low-return or investments that will go to zero. That is the whole premise of venture capital.

Foreign Direct Investment

foreign-direct-investment
Foreign direct investment occurs when an individual or business purchases an interest of 10% or more in a company that operates in a different country. According to the International Monetary Fund (IMF), this percentage implies that the investor can influence or participate in the management of an enterprise. When the interest is less than 10%, on the other hand, the IMF simply defines it as a security that is part of a stock portfolio. Foreign direct investment (FDI), therefore, involves the purchase of an interest in a company by an entity that is located in another country. 

Micro-Investing

micro-investing
Micro-investing is the process of investing small amounts of money regularly. The process of micro-investing involves small and sometimes irregular investments where the individual can set up recurring payments or invest a lump sum as cash becomes available.

Meme Investing

meme-investing
Meme stocks are securities that go viral online and attract the attention of the younger generation of retail investors. Meme investing, therefore, is a bottom-up, community-driven approach to investing that positions itself as the antonym to Wall Street investing. Also, meme investing often looks at attractive opportunities with lower liquidity that might be easier to overtake, thus enabling wide speculation, as “meme investors” often look for disproportionate short-term returns.

Retail Investing

retail-investing
Retail investing is the act of non-professional investors buying and selling securities for their own purposes. Retail investing has become popular with the rise of zero commissions digital platforms enabling anyone with small portfolio to trade.

Accredited Investor

accredited-investor
Accredited investors are individuals or entities deemed sophisticated enough to purchase securities that are not bound by the laws that protect normal investors. These may encompass venture capital, angel investments, private equity funds, hedge funds, real estate investment funds, and specialty investment funds such as those related to cryptocurrency. Accredited investors, therefore, are individuals or entities permitted to invest in securities that are complex, opaque, loosely regulated, or otherwise unregistered with a financial authority.

Startup Valuation

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Startup valuation describes a suite of methods used to value companies with little or no revenue. Therefore, startup valuation is the process of determining what a startup is worth. This value clarifies the company’s capacity to meet customer and investor expectations, achieve stated milestones, and use the new capital to grow.

Profit vs. Cash Flow

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Profit is the total income that a company generates from its operations. This includes money from sales, investments, and other income sources. In contrast, cash flow is the money that flows in and out of a company. This distinction is critical to understand as a profitable company might be short of cash and have liquidity crises.

Double-Entry

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Double-entry accounting is the foundation of modern financial accounting. It’s based on the accounting equation, where assets equal liabilities plus equity. That is the fundamental unit to build financial statements (balance sheet, income statement, and cash flow statement). The basic concept of double-entry is that a single transaction, to be recorded, will hit two accounts.

Balance Sheet

balance-sheet
The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).

Income Statement

income-statement
The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).

Cash Flow Statement

cash-flow-statement
The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.

Capital Structure

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The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).

Capital Expenditure

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Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed asset, with a longer term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.

Financial Statements

financial-statements
Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.

Financial Modeling

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Financial modeling involves the analysis of accounting, finance, and business data to predict future financial performance. Financial modeling is often used in valuation, which consists of estimating the value in dollar terms of a company based on several parameters. Some of the most common financial models comprise discounted cash flows, the M&A model, and the CCA model.

Business Valuation

valuation
Business valuations involve a formal analysis of the key operational aspects of a business. A business valuation is an analysis used to determine the economic value of a business or company unit. It’s important to note that valuations are one part science and one part art. Analysts use professional judgment to consider the financial performance of a business with respect to local, national, or global economic conditions. They will also consider the total value of assets and liabilities, in addition to patented or proprietary technology.

Financial Ratio

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WACC

weighted-average-cost-of-capital
The Weighted Average Cost of Capital can also be defined as the cost of capital. That’s a rate – net of the weight of the equity and debt the company holds – that assesses how much it cost to that firm to get capital in the form of equity, debt or both. 

Financial Option

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A financial option is a contract, defined as a derivative drawing its value on a set of underlying variables (perhaps the volatility of the stock underlying the option). It comprises two parties (option writer and option buyer). This contract offers the right of the option holder to purchase the underlying asset at an agreed price.

Profitability Framework

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A profitability framework helps you assess the profitability of any company within a few minutes. It starts by looking at two simple variables (revenues and costs) and it drills down from there. This helps us identify in which part of the organization there is a profitability issue and strategize from there.

Triple Bottom Line

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The Triple Bottom Line (TBL) is a theory that seeks to gauge the level of corporate social responsibility in business. Instead of a single bottom line associated with profit, the TBL theory argues that there should be two more: people, and the planet. By balancing people, planet, and profit, it’s possible to build a more sustainable business model and a circular firm.

Behavioral Finance

behavioral-finance
Behavioral finance or economics focuses on understanding how individuals make decisions and how those decisions are affected by psychological factors, such as biases, and how those can affect the collective. Behavioral finance is an expansion of classic finance and economics that assumed that people always rational choices based on optimizing their outcome, void of context.

Connected Video Lectures

Read Next: Biases, Bounded Rationality, Mandela Effect, Dunning-Kruger

Read Next: Heuristics, Biases.

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About The Author

Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
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