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1 1 (September 5, 2024)

handle is hein.crs/goveqnh0001 and id is 1 raw text is: Congressional Research Service inforrning thw eagslative debate since 1914 September 5, 2024 Too Big to Fail Financial Institutions: Policy Issues Some financial institutions are perceived to be too big to fail (TBTF), meaning that their failure would trigger financial instability. Although the term TBTF is a popular shorthand, too interconnected to fail is considered to be a more apt phrase to describe these firms because they are the key participants in a certain market or because their failure would cause counterparties to fail. Size is a primary-but not the sole-factor influencing interconnectedness. The federal government does not recognize any firm as TBTF, as it does not want to imply that it would provide assistance to prevent the firm's failure. But it does recognize some firms as posing systemic risk. TBTF has been a long-standing policy concern. Events in 2008 illustrated the systemic risk posed by TBTF institutions, as the failure or near failure of several caused a severe financial crisis and deep economic recession. Both banks and nonbank financial institutions-including investment banks Bear Stearns and Lehman Brothers, insurer AIG, and government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac-proved to be TBTF in 2008. The Treasury, the Federal Reserve (Fed), and the Federal Deposit Insurance Corporation (FDIC) provided these firms (with the exception of Lehman Brothers) with so-called bailouts-exclusive ad hoc financial assistance backed by taxpayers to prevent their failure or facilitate their (voluntary or involuntary) takeovers by solvent firms. This eventually restored financial stability by giving financial markets confidence that more large firms would not fail. In 2023, the failure of three banks with over $100 billion in assets (whereas the very largest banks have over $1 trillion in assets) triggered bailouts: The FDIC used emergency authority to guarantee the uninsured deposits of Silicon Valley Bank (SVB) and Signature Bank. As this case illustrates, some creditors (uninsured depositors) may receive bailouts, but others (bondholders) or the banks themselves-which were liquidated-may not. TBTF raises concerns about fairness and reduces economic efficiency if it causes moral hazard-the concept that an actor will be more reckless if shielded from risk. In this case, firms have an incentive to increase expected profits by taking riskier positions-thereby increasing systemic risk- if they believe the government will bail them out if those positions result in debilitating losses. Current Poicy Regulation of a large firm depends on how it is legally structured. Some financial institutions-such as banks, bank holding companies (BHCs), and GSEs-are federally regulated and supervised for safety and soundness (called prudential regulation), whereas firms operating solely in capital markets do not face similar regulation. Since 2008, the two GSEs have been in government conservatorship under a new regulator that has closely circumscribed their operations. Insurers are subject to prudential regulation at the state level rather than on a consolidated basis across states and noninsurance subsidiaries. The Dodd-Frank Act (P.L. 111-203) reformed financial regulation in response to the crisis. It tried to mitigate TBTF through a new enhanced prudential regulatory (EPR) regime administered by the Fed for large BHCs and nonbanks designated as systemically important financial institutions (SIFIs) by the Financial Stability Oversight Council (FSOC). It also applied heightened risk management standards to payment, clearing, and settlement systems designated as systemically important financial market utilities (SIFMUs) by FSOC. FSOC is chaired by the Treasury Secretary and largely composed of the financial regulators. Dodd-Frank also created a new FDIC resolution regime (called Orderly Liquidation Authority) for financial firms (including BHCs but excluding banks) deemed TBTF at the time of their failures based on the logic that a bailout can be avoided if a firm can be wound down safely. It is modeled on bank resolution and has never been used. The law also added new limits on Fed and FDIC emergency assistance in an effort to limit bailouts. The Dodd-Frank Act made all large U.S. BHCs and intermediate holding companies of foreign banks (IHCs), as well as nonbank SIFIs, subject to EPR. EPR was intended to impose more stringent prudential requirements than those applied to other firms to account for the systemic risk they posed. The Fed implemented new regulatory requirements for BHCs to undergo stress tests, submit capital plans and resolution plans (living wills), hold more capital and liquidity, limit counterparty exposure, and comply with risk management requirements. In 2018, P.L. 115-174 (often referred to as S. 2155) raised the asset threshold for BHCs subject to EPR from $50 billion to $250 billion while providing the Fed discretion to apply tailored EPR standards to BHCs with between $100 billion and $250 billion in assets. The Fed implemented this change through a rule that placed BHCs into four categories and applied tiered standards to each category. Only one bank subject to EPR has failed since enactment: SVB was a Category IV bank subject to the least stringent EPR standards. There are currently 26 U.S. BHCs and 10 IHCs subject to EPR. After enactment of the Dodd-Frank Act, FSOC designated three insurers (AIG, Prudential, and MetLife) and one nonbank lender (GE Capital) as SIFIs (see Table 1). Originally perceived as a start, the four designations instead proved to be the high mark. By 2018, all four were de- designated due to business changes, court decisions, and changes in the philosophy ofFSOC leadership. There have

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