During the Global Financial Crisis (GFC), governments worldwide intervened to rescue globally systemically important banks (GSIBs), fearing their collapse could shatter the world economy. Branded as ‘too big to fail’, these financial giants had historically been regarded as ‘immune’ from insolvency, backed by the belief that governments would always step in. But new research from The Australian National University College of Business and Economics (CBE) suggests this may be changing, as data spanning from 2001 to 2022 reveals bailouts were perceived less probable than before the crisis.
A study conducted by Professor Antje Berndt and Dr Yichao Zhu, from the ANU Research School of Finance, Actuarial Studies and Statistics, and by Professor Darrell Duffie from Stanford University, reveals that the likelihood of an insolvent, globally systemically important bank not being bailed out by government has more than doubled after the financial crisis.
Published in American Economic Review, one of the oldest and most respected scholarly journals in economics, the study examined credit risk pricing and financial reporting data for six large United States (U.S.) banks from 2001 to 2022.
“Our research finds significant reductions in market-implied probabilities of government bailout after the global financial crisis, along with roughly 170 percent higher wholesale debt financing costs for these banks after controlling for insolvency risk,” Yichao says.
“Since the crisis, bank creditors appear to expect much larger losses in the event that a globally systemically important bank approaches insolvency. In this sense, we estimate a decline of ‘too big to fail’.”
The origins of ‘too big to fail’
In 2008, the U.S. housing market crash sent shockwaves through the global economy. Major financial institutions such as Washington Mutual defaulted, with the ripple effects causing millions of people to lose their jobs and homes.
Some banks were deemed ‘too big to fail’—so large and intertwined with the economy that governments had no choice but to inject capital into them, despite their contributing role in the subprime loan crisis.
The term ‘too big to fail’ was popularised by U.S. Congressman Steward McKinney in 1984 to describe the government’s rescue of Continental Illinois Bank, but it was only after the 2008 global financial crisis that it became widely known.
In November 2011, the Financial Stability Board (FSB) introduced the Globally Systemically Important Banks (GSIBs) list, identifying 30 institutions that could jeopardise the global financial system if they were to fail.
These banks are today closely monitored by international regulators to prevent global economic downturn.
“The insolvency of these banks, which play a crucial role in the global financial system, can have widespread negative effects, such as freezing interbank lending, causing asset price collapses, disrupting payment systems and amplifying economic losses,” says Antje.
“This was evident in the 2008 financial crisis, particularly with the collapse of Lehman Brothers and near-failure of other financial institutions, which triggered severe market turmoil.”
Can GSIBs truly collapse?
During the years following the crisis, the global financial system was reformed with the introduction of numerous policies designed to prevent a future crisis, such as the Dodd-Frank Act, enacted during Barack Obama’s presidency.
However, despite stricter regulations to supervise large, interconnected banks, GSIBs remain vulnerable.
“GSIBs can become insolvent, as we saw with Credit Suisse in 2023,” says Yichao.
Two years ago, Swiss banking giant Credit Suisse—a 167-year-old institution included in the GSIBs list—collapsed, forcing a government-assisted emergency acquisition by direct competitor UBS Group AG, which prevented a crisis that could have spread over the global financial markets.
Antje’s and Yichao’s findings are an important reminder that, in today’s world, the risks of big-bank insolvency are still omnipresent.
If another crisis hits and wholesale creditors face steep losses, will governments intervene?
“Our study ends in 2022, so we can only speak to the post-GFC period that ends then. We estimate that during this period, the market-implied probability of an insolvent GSIB not getting bailed out was more than twice as high as it was before the crisis,” says Antje.
Read more about Antje’s and Yichao’s research, published in American Economic Review.
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