TBTF As A Motive For Bank Mergers
Author: LawSphereX
Category: Corporate & Insolvency
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TBTF AS A MOTIVE FOR BANK MERGERS
Samridhi Pal, Amity Institute of Advanced Legal Studies, Amity University, Noida
ABSTRACT
The notion of “Too Big to Fail” (TBTF) has been essential in shaping the landscape of the banking sector, particularly as a motive for bank mergers. This concept came to the fore with the advent of the financial catastrophe of
2008. TBTF institutions were at the heart of the crises. Banks pursue M&A
not only for economies of scale, competitive advantages but also for achieving the TBTF status. TBTF doctrine influences financial institutions’ strategic decisions, driving consolidation efforts to achieve size and systematic importance. However, at the same time, TBTF banks and financial institutions has it’s own associated risks and problems like creation of moral hazard, systematic risks etc which pose significant challenges to financial stability of an economy especially during a financial crises. Hence, it is not incorrect to state that TBTF is a blend of both positive and negative aspects, when studied as a motive for bank mergers. Keywords: TBTF; Too Big to Fail; M&A; Banks; Financial institutions; Motive; Crises
THE CONCEPT OF “TOO BIG TO FAIL” (TBTF)
A Corporation is referred to as a TBTF organisation when it becomes so big and intertwined
that its failure would be a nightmare for the entire country. 1 A TBTF can also be understood as a firm whose proportion, complexity, interlinkedness and key roles are such that, if the entity goes unpredictably into dissolution, the remainder of the banking industry and the nation would encounter serious negative results. 2 TBTF bank is also labelled as Systematically Important Banks. There are two categories of Systematically Important Banks namely, Global Systematically Important Banks (GSIBs) and Domestic Systematically Important Banks (DSIBs). Regulations both at the international level and national level regarding TBTFs help to regulate their functioning and work in order to prevent failure of TBTFs which can in turn trigger a catastrophe in the entire economy.
The financial catastrophe of 2008 brought to the political and regulatory fore the concept of financial entities that were “too big to fail” (TBTF). TBTFs were at the centre of the catastrophe. These institutions were the initial beneficiaries of the bailouts from the US government and other federal actions to avert them from failing to meet their debt obligations. 3 More than 200 banks failed during the 2008 catastrophe, resulting in losses of more than $3 trillion. 4 In this crucial time, federal watchdogs classified some financial firms, systematically important, believing that collapse of even a single firm would have potentially widespread effects.
As a result, the sustenance of these systematically important firms was considered tightly linked with the well being of the entire financial arena of a nation, based on this, the bailouts provided by USA government were considered justified. Furthermore, big banks got preference as they played a vital role in the daily working of nation. It was feared that the failure of these big, interlinked banks will result in substantial disturbance in the wider economy. 5
1 Amir Bilal Mahmood, “Role of too big to fail companies in the financial crises,” 12 JISR-MSSE 2014
2 Ben S. Bernanke, “Statement by Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System,” (Financial Crises Inquiry Commission, Sept 2010)
3 Paul H. Schultz Perspectives on Dodd-Frank and Finance (The MIT Press, 2014)
4 Statistics refer to the years 2007-2009 and were obtained from the Federal Deposit Insurance Corporation (FDIC), accessed through the Federal Reserve Economic Data-FRED-Federal Reserve Bank of St. Louis Website available at https://fred.stlouisfed.org (Last visited on February 21, 2025)
5 Gregory D. Maslak and Gonca Senel, Bank Consolidation and Systematic Risk: M&A During the 2008
Financial Crises (2019) (Department of Economics, Bowdoin College)
TBTF AS A MOTIVE OF BANK MERGER
Banks and other financial institutions are often lured by the idea of becoming a TBTF through merger. There are some perceived advantages when TBTF acts as a motive for bank mergers.
1. Increased Financial Stability and Access to Capital
Achieving a TBTF status results in banks and other organisations becoming more resilient to localise shocks because of their more diversified income, streams, and investments. A TBTF or a Systematically Important Bank has a larger access to capital in comparison with a smaller bank.
2. Increased Market Share and Power
Bank merger motivated by the goal of achieving a TBTF status results in banks gaining a larger market share and considerable power which in turn provides the combined entity greater clout and negotiating leverage in the market. Further, as a bank gains TBTF status it results in improved investor and depositor confidence, lowering funding costs and stabilising operations.
3. Positive Impacts on Credit Ratings and Stock Price Changes
A merger to create a TBTF also attracts positive reactions from the market in the sense that it
results in changes in stock prices. The coming into force of the Gramm-Leach-Riley Act or the Financial Services Modernisation Act, 1999, which led to consolidation of commercial banks, security businesses, insurance provider businesses, investment banks witnessed stock price changes. The market responded positively, expressing its anticipation of profits from these businesses’ merger, and eventually from TBTF Guarantees.6 Further, TBTF has a positive impact on credit ratings. Studies conducted have suggested that banks with TBTF status have positive reflection on credit ratings. Reversion of the issuer ratings against the bank’s economic health rating and outside support variables that impact the debt’s ability to be repaid.7
4. Access to Government Support and Bailouts
The bank consolidation is often motivated by the goal of creating a TBTF due to the access of 6 Yu, L., “On the Wealth and Risk of the Glass-Steagal Overhaul: Evidence from the Stock Market,” available at https://ssrn.com/abstract=354389 (Last visited on April 5, 2025) 7 Bertrand Rime, Do “too big to fail” expectations boost large banks issuer ratings? (Working Paper, 2005)
government support and issuance of bailouts to these banks and financial organisations during times of financial catastrophe to prevent their failure. The bailouts to these institutions is considered as a positive incentive by the policymakers and organisations: Ø After averting uncertainty in the economic industry against aggravating and spilling throughout the nation, the benefits of shielding exceeded the drawbacks. It is universally acknowledged that “too big to fail” position is vital in supporting vibrant financial activity. 8 Ø It may be in the interest of policymakers to bail out large banks, as such actions could enhance their personal or political standing. For instance, assisting uninsured lenders might promote the development of a policymaker’s career. 9 Ø According to policymakers, directing credit through government intervention can enhance society’s long term welfare.
They argue that the long standing benefits from shielding uninsured lenders exceed the moral hazard risks such protection may create. 10 Ø Another possible motivation behind protection of TBTF in times of financial catastrophe is personal motivation. However, when compared with concerns over losses to the entire nation, personal motivation is less important. Government bailout, large banks, fearing their failure during a financial crisis out of their apprehension that lenders loses from one banking institution can quickly spread through the entire banking system resulting in enormous losses in the financial system. Further, protecting these large banks is also important as their failure can result in huge job losses. 11
5. Economies of Scale
Through operational efficiency and technological integration post merger, large banks are in a position to reduce costs per unit of output. 8 Aurelija Stankute, Discuss the concept of “too big to fail” within the financial sector. What are the arguments in favour of this concept, and what are possible negative consequences? (Department of Economics, University of Essex, 2011)
9 Id
10 Id
11 Stern, G.H. and Feldman, R.J., Too big to fail: The hazards of bank bailouts (Brookings Institution Press, Washington D.C., 2009)
6. Enhanced Global Reach
The banks often aim for achieving TBTF status in order to expand globally and compete with global financial giants. Apart from the above, diversification, risk reduction, improved resource allocation, synergy creation, increased goodwill in the market, reduced regulation costs also are some of the advantages linked with creation of a TBTF through merger.12
DRAWBACKS OF TBTF AS A MERGER MOTIVE
Bank consolidation influenced by the motive to create a TBTF is not free from it’s share of problems and challenges. It is the risk associated with the emergence and expansion of large banks which is commonly known as “too big to fail” problem. This problem gets even worse when large banks merge to create a mega bank. 13 An example of how the failure of a TBTF can be risky for the sustenance of the entire economy is the failure of Lehman Brothers during financial catastrophe, 2008.
It was a systematically important bank or TBTF which expediated the financial crisis, leading to widespread economic turmoil, combined with job losses and encouraging the USA government to resort to every measure to at least contain the remaining of the systematically important undertaking in banking sector because failure of such banks can have a deep influence on the entire nation shows that bank mergers should not be motivated by creation of TBTF as distress in a single TBTF can create a havoc. Apart from the above, there are a variety of other reasons which suggest that creation of TBTF as a motive of bank merger should be avoided.
1. TBTF considered socially undesirable
There are several reasons why banks having TBTF status are considered socially undesirable. Firstly, there might be costs associated with the public injunctions of shareholders equity into TBTF banks that ultimately collapse. Public injections are also capable of generating deadweight cost. A stand-in for these expenses may be measures of the worth of the
12 Supra note 1
13 Gary H. Stern and Ron J. Feldman, “Addressing TBTF When Banks Merge: A Proposal,” September 1, 2005, available at https://www.minneaspolisfed.org/article/2005/addressing-tbtf-when-banks-merge-a-proposal (Last visited on April 5, 2025)
government’s covert assistance to TBTF institutions. Secondly, “too big to fail” can alter behaviour ex ante. This alteration arises as these banks might enjoy lesser debt costs as lenders expect that if these banks were intimidated with collapse, they would be bailed out rather than default on debt obligations. TBTF banks financing benefits can lead to TBTF banks to make inept resolutions.14 There are other economic effects of TBTF like in case of disruptions of a large firm, it could lead to ‘fire sales’ as happened with the consolidation of JP Morgan Chase and Bear Streans during the 2008 financial crisis.15
2. Spillover effects
Also, another reason why TBTF should be evaded, is that in case of distress in a single TBTF, the resolution to consolidation will just lead to an even massive bank. The outcome of a consolidation can potentially increase the risk to the steadiness of the overall economic sector.
16 If distress, is present in a TBTF then merging it with another bank could also result in
spillover effects.
3. Moral Hazard
Creation of TBTF is also critiqued of contributing to financial crises. The regulatory changes that facilitated emergence of TBTF, universal banks and the increasing reliance on internal models, which enabled these banks to report higher capital levels, despite increase in risk, embracing ‘light touch’ regulation in the UK and Europe, et cetera, all played a role in exaggerating the housing price bubble. 17 The enhancement of the catastrophe was mainly owing to size, complexity, interconnectedness of the banking sector. Several so called TBTF firms, that had balance sheets bigger than the GDP of some of the countries and had close connection with the rest of the economic system, were at the heart of this enhancement process.
Due to their complexity and interconnectedness resulting from their size, governments were compelled to intervene and rescue them as their collapse could do severe damage to the economic sector and the nation. This results to a significant moral hazard. If creditors are aware that these institutions will be bailed out, there is no motivation for them to impose market 14 Caspar Siegert and Matthew Willison, Estimating the extent of the ‘too big to fail’ problem- a review of existing approaches (Financial Stability Paper No. 32, Bank of England, February 2015) 15 Marc Labonte, Systematically important or “too big to fail” financial institutions, (Congressional Research Service, 2015)
16 Supra note 5
17 Tamim Bayoumi, Unfinished Business: The unexplored causes of the financial crisis and the lessons yet to be learned, (Yale University Press, September 2017)
discipline and reduce the risk taking activities. The management is also motivated to take on more risk as it expects the authorities to rescue them in case it goes haywire.18 The TBTF concept leads to creation of moral hazard, as such banks are well aware that they would be recipient of government support and bailouts if things go downhill, they are incentivised to take on excessive risks.
4. Difficulty in managing operations.
As a bank expands, it becomes harder. to oversee its operations, and that if the bank begins to fail, it jeopardises, the entire economy.19
5. Threat to consumer welfare
Although TBTF is not main to most merger analysis, significant customer hub has resulted from allowing corporate growth to create so many indispensable firms. Permitting firms to amalgamate into a size that cannot be risked to collapse through regular bankruptcy proceedings poses a risk to consumer welfare similar to the harms caused by mergers, we already blocked for other reasons.20
6. Legal Precedents and government regulations avoiding TBTF
The principle that bank mergers should not achieve TBTF status is backed, bye, various legal precedents and regulatory policies which highlight that mergers resulting in excessive market concentration or systematic risk go against antitrust laws and financial stability objectives. Ø BCBS (Basel Committee on Banking Supervision) has also categorised Global Systematically Important Banks (G-SIBs) and also Domestic Systematically Important Banks (D-SIBs) using characteristics of size, complexity and interconnectedness and their potential impact on domestic economy respectively.21
18 Rabi N. Mishra, Systematic risk and macro prudential regulations,73 (Sage Academic Books, 2020)
19 Punam Agarwal, “Merger and Acquisition of Indian Bank: Boon or Curse for Indian Economy” 1 IJRAW 01 (2022) 20 Jesse W.W. Markham “ Lessons for competition law from the economic crisis: the prospect for anti trust responses to the “too big to fail” phenomenon 16 Fordham Journal of Corporate & Financial Law 2011 21 Ayeshi Verma and Dr. Jyoti Bhargava, “Evolution of D-Sibs in India: A study of the “Too Big to fail” concept,”
12, IJCRT, 237-243 (2024)
Ø United States vs. Philadelphia National Bank, in this landmark antitrust case, the USA apex Court ruled against the merger of two major banks in Philadelphia observing that the amalgamation would control enormous share of the commercial banking market in the area. The court determined that mergers leading to undue concentration of market power, unlawful under Clayton Act. This decision highlights that mergers intended to create dominance, potential leading to TBTF status are inconsistent with anti-trust principles. 22 Ø The collapse-of Continental Illinois National Bank resulted in significant federal bailout as regulators considered the bank TBTF. This event exposed the systematic risk posed by massive, complex financial institutions and sparked debates about the moral hazard linked with banks expanding in sizes where their collapse could threaten the financial system.
The case illustrates the risks of banks growing through mergers to a point where a size associates, government intervention in crisis. Ø FDIC merger guidelines, the FDIC has updated it’s bank merger guidelines to emphasise supervision of mergers that could result in institutions becoming systematically important. The guidelines emphasise preserving financial stability and averting the creation of entities whose collapse could threaten the entire economy. This regulatory stance shows a commitment to averting merger driven by the motive to create TBTF. Ø The USA Department of Justice ( DOJ) antitrust division has eliminated outdated bank merger guidelines to include broad anti-trust principles that assess the competitive effect of mergers across industries, including banking.
This approach ensures that mergers leading to excessive market, concentration or systematic risk, thoroughly evaluated and if necessary challenged.
7. Systematic risks
Merger which creates a TBTF leads to reduction in resiliency. Bank mergers motivated by creation of TBTF leads to increased systematic risk and lacks robustness. The core idea is that the government will intervene to save an organisation in distress if the organisation is deemed
22 374 U.S. 321 (1963)
crucial to the economy. This leads to a classic situation of moral hazard, where an organisation can act recklessly during times of prosperity knowing that it won’t fully suffer from a downturn. TBTF engage in risky lending practices thereby lowering robustness. 23 Size of banking firm, it is a crucial factor considered when examining financial steadiness, as banking firms of varied proportion are subject to varying legislative scrutiny and might lead to effects on financial steadiness, for example, TBTF banks. FRB extends a protective harbour for “merger proposals involving an acquisition of less than 0 billion in total assets, for that result in a firm with less than hundred billion dollars in total assets.
” while mergers consisting of massive banking firms with combine capital of hundred billion dollar or more are looked upon to book substantially more losses per quarter at the time of a bad economic downturn, smaller consolidations under billion have little impact on financial results.. It shows that proportion matters in calculating the elasticity outcomes of bank consolidation, a theory corroborating with the TBTF and increase of moral Hazard. 24
INDIAN POSITION ON TBTF
In India, while there are few direct case laws relating the TBTF doctrine, few regulatory actions and legal precedents have influenced the approach towards systematically important financial institutions. The RBI has established regulatory structure to discover and regulate Domestic Systematically Important Banks (D-SIBs) whose collapse could enormously affect the entire financial system. These banks will be mandated to have an additional capital buffer and capital surcharge starting in April 2025. 25 This regulatory framework established by RBI under the direction of Raghuram Rajan initiated the process of recognising D-SIB’s in 2015. Some factors considered for identifying D-SIBs include size, interconnectedness, complexity and limited replacements or financial institutions infrastructure. 26 The crisis involving Yes Bank in 2020, serve as a classic example.
Facing significant liquidity concerns and potential failure, the RBI interjected by implementing a restructuring plan. This
23 Jeffrey Jou, Teng Wang et.al., “Are bank merger is bad for financial stability?” available at
https://www.fdic.gov/system/files/2024-09/jou-presentation-091724.pdf (Last visited on March 28, 2025)
24 Id
25 India cenbank retains SBI, HDFC Bank, ICICI Bank, in too-big-to-fail list, available at
https://www.reuters.com/business/finance/india-cenbank-retains-sbi-hdfc-bank-icici-bank-too-big-to-fail-list- 2024-11-13/ (Last visited on March 28, 2025)
26 Supra note 21
plan consisted of a capital infusion led by SBI and other private banks, along with regulatory assistance to stabilise the bank. The intervention highlights he regulatory stance while certain banks are crucial to the economic sector, the operations and expansion must be handled prudently to avert systematic crisis.27
CONCLUSION
The TBTF concept remains a subject of ongoing debate with some favouring creation of TBTF while others who consider that long term risks and challenges are associated with a merger resulting in TBTF. In response to the 2008 crises, regulations at the domestic level and worldwide standards in form of Basel guidelines have been implemented to address TBTF problems, like stricter liquidity and capital requirements for such banks, stricter regulatory oversight, enhanced merger guidelines amongst others. In the end, reducing the systematic risk associated with TBTF institutions is essential to maintain long term financial stability and preserving public confidence in the economic sector.
27 Salil Gupta, “India: Yes Bank Restructuring 2020” 6 journal of financial crises 2024