too big to fail

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The notion that certain banks will always be supported in a crisis, because their failure would have an unacceptable effect on the stability of the national or international financial system. If such a bank should get into trouble, it is argued, the central bank would be sure to bail it out. It is further contended that an awareness of this fact creates a significant moral hazard by making such a bank more willing to take risks. The counterargument is that even if it received aid, there might still be serious consequences for the managers and shareholders of the bank. In any case, the theory only applies to the largest financial institutions. For example, in 1995 the merchant bank Barings plc was allowed to fail after sustaining major losses through irregular trading on the derivatives market, since the Bank of England could identify no systemic risk resulting from its failure. In 2007–08, however, the Bank of England and HM Treasury provided over £25 bn of emergency support to the mortgage bank Northern Rock, one of the UK's biggest lenders; the bank was subsequently nationalized. Similarly, in 2008 the US mortgage giants Fannie Mae (see Federal National Mortgage Association) and Freddie Mac (see Federal Home Loan Mortgage Corporation) were taken into temporary public ownership following a disastrous fall in their share prices – the biggest government bail-out in financial history.

Subjects: Economics — Business and Management.

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