Question

Use the following news clip to work Problems 13 and 14 The World's 29 Too Big to Fail Banks, JP Morgan at the Top The Financial Stability Board has released the latest list of the world's too-big-to-fail banks. Each year, the board examines banks to decide which ones pose a threat to the global economy if they were to fail. Those on the list of too-big-to- fail must hold more capital to absorb potential losses, and therefore protect taxpayers from bailouts. In \(2013, \mathrm{JPM}\) and \(\mathrm{HSBC}\) top the list. This means they must each hold an extra \(2.5 \%\) of capital on top of the additional \(7 \%\) that will be required down the road. Source: www.forbes.com, November 11,2013 Explain how the failure of big banks would be disastrous for the economy?

Short answer

The failure of large banks would lead to reduced credit availability, financial panic, and potentially a systemic collapse of the global economy.

Step-by-step solution

- Understand the Context

The exercise is about the implications of the failure of large banks, using information from a news clip. These banks are considered 'too big to fail', meaning their collapse could have severe repercussions on the global economy.

- Define 'Too Big to Fail'

'Too big to fail' refers to financial institutions that are so large and interconnected that their failure would be disastrous for the broader economy. These institutions must maintain higher capital reserves to prevent potential losses and protect taxpayers.

- Identify Reasons for Economic Impact

Big banks play a crucial role in the global economy by providing loans, facilitating transactions, and maintaining financial stability. Their failure would lead to a cascade of problems, such as reduced credit availability, loss of savings, and a crisis of confidence in the financial system.

- Highlight Potential Consequences

The specific consequences of a big bank's failure would include a significant credit crunch (difficulty in obtaining loans for businesses and consumers), widespread financial panic, and the risk of a domino effect causing other financial institutions to fail.

- Conclusion

In summary, the failure of large banks would be disastrous due to their central role in the economy, causing a severe credit crunch, financial panic, and potential systemic collapse.

Key concepts

Financial Stability

Financial stability refers to the condition where the financial system operates smoothly without crises. This is crucial because the financial system includes banks, markets, and payment systems that support the economy. When large banks, labeled as 'too big to fail', are healthy and stable, the financial system is more likely to remain stable. However, if these banks face significant losses or collapse, it can lead to serious disruptions. Financial stability ensures that banks have sufficient capital buffers to absorb losses. This is essential to keep confidence in the financial system intact. If confidence falters, it can lead to a financial panic, with everyone scrambling to withdraw their money, which further destabilizes the economy.
In essence, maintaining financial stability involves proactively managing risks and ensuring that financial institutions have the resilience to withstand shocks. This involves strict regulations, regular stress testing, and maintaining a robust supervisory framework.

Economic Impact

The economic impact of large banks failing would be vast. Banks are intertwined with every sector of the economy, providing critical services such as loans for businesses and individuals, managing savings, and processing payments. If a big bank collapses, it would result in a loss of confidence and trust in the financial system.
Businesses would struggle to secure loans for operations and expansion, leading to lower investment and possibly closures. Consumer spending would also decrease as individuals find it difficult to access credit. Additionally, there would be a significant knock-on effect, affecting smaller banks and financial institutions, creating a domino effect. This would result in widespread economic disruptions, potentially leading to a recession.
Therefore, the economic impact of the failure of large banks extends well beyond the financial sector, affecting the overall health and stability of the economy.

Capital Reserves

Capital reserves are the funds that banks must hold to cover potential losses. For 'too big to fail' banks, maintaining higher capital reserves is critical. These reserves act as a buffer during financial downturns, helping banks absorb losses without collapsing. The idea is to prevent the need for taxpayer-funded bailouts, which were common during past financial crises.
For instance, according to the news clip, JPMorgan and HSBC were required to hold an extra 2.5% of capital on top of an additional 7% in 2013. This means that they needed more financial padding to shield against unforeseen losses. Higher capital reserves ensure that banks are more resilient and can sustain themselves during economic stress. This protective measure is crucial to avoid systemic risks and to promote a stable financial environment.

Credit Availability

Credit availability refers to the ease with which businesses and consumers can borrow money. Banks are the primary source of credit, and their health directly affects the availability of credit in the economy. When big banks are stable and functioning well, they can lend money to businesses for expansion, to consumers for homes and cars, and even to other banks.
However, if a large bank fails, it disrupts the flow of credit. Businesses may find it difficult to get loans to operate and grow, leading to unemployment and reduced economic activity. Consumers would also struggle to secure personal loans, mortgages, and other forms of credit, affecting their spending. This reduction in credit availability can lead to a credit crunch, where borrowing becomes scarce and expensive, further slowing down the economy.

Thus, ensuring that large banks remain healthy is vital for maintaining steady credit availability, which in turn supports robust economic growth and stability.