SIFIs and Too-Big-to-Fail
A systemically important financial institution (SIFI) is one whose disorderly failure would threaten the whole system because of its size, interconnectedness, complexity, and lack of substitutes. The largest are designated global SIBs (G-SIBs) by the FSB and carry extra capital surcharges. Too-big-to-fail (TBTF) is the expectation that authorities will rescue such a firm rather than let it collapse. That implicit guarantee creates moral hazard: protected firms can borrow cheaply and take more risk, since they keep the upside while the public bears the downside. Farhi and Tirole (2012) show this becomes collective: many institutions choose to be exposed to the same risks, knowing a regulator cannot let them all fail at once.
Why it matters
TBTF is a safety net that quietly changes behavior. If everyone knows the state will catch a giant bank, lenders treat its debt as nearly government-guaranteed, so it funds cheaply and is tempted to take bigger bets. Worse, the smart strategy is to fail in a crowd: if your bank is fragile in the same way as everyone else, the regulator must bail out the whole group, so correlated, herd-like risk-taking is rewarded. The guarantee meant to protect the system ends up encouraging the very fragility it must then rescue.
Formulas
Worked examples
After 2008, regulators bailed out or backstopped large institutions (e.g., AIG) but let Lehman fail. What lesson did markets draw, and what risk did it create?
Markets inferred that sufficiently large, interconnected firms enjoy an implicit guarantee, reinforcing the TBTF expectation. The moral hazard is that such firms face a lower cost of debt and weaker market discipline, encouraging more leverage and risk. The policy response, G-SIB surcharges and resolution regimes, aims to offset that subsidy and make failure survivable.
Farhi and Tirole (2012) argue bailouts breed "collective moral hazard." What does that mean in practice?
Individually, each bank knows that if many banks are simultaneously distressed, the central bank cannot let them all fail, so a system-wide bailout (for example, cheap liquidity) is assured. The optimal private response is to correlate exposures, for example all borrowing short and holding similar maturity-mismatched assets, so that maturity transformation is excessive and risk is herded by design. The guarantee thus endogenously produces the correlated fragility it must later rescue.
In March 2023 Credit Suisse, a designated G-SIB, lost market confidence and was taken over by UBS in a Swiss-government-brokered deal (about CHF 3 billion) on 19 March. What does this show about the G-SIB framework?
Higher loss-absorbing capital and G-SIB surcharges make a systemic firm more resilient, but they do not remove the too-big-to-fail problem: when confidence and funding evaporate, authorities still arranged a rescue rather than risk a disorderly failure of a globally interconnected bank. It illustrates that capital surcharges reduce, but do not eliminate, the implicit guarantee, which is why resolution regimes (orderly wind-down tools) sit alongside surcharges.
Common mistakes
- ✗A SIFI is simply the biggest bank by assets. Size is one input, but interconnectedness, complexity, substitutability, and cross-jurisdictional activity also determine systemic importance; a smaller, highly interconnected firm can be systemic.
- ✗Too-big-to-fail protects taxpayers. The implicit guarantee subsidizes risk-taking and can shift losses onto the public; it protects creditors of the firm, not taxpayers, and creates moral hazard.
- ✗Moral hazard from bailouts is only an individual-firm problem. Farhi and Tirole show it is collective: firms rationally correlate their risks so a regulator cannot refuse a system-wide rescue.
Revision bullets
- •SIFI: failure threatens the system via size, interconnectedness, complexity, substitutability
- •G-SIBs are designated by the FSB and carry capital surcharges
- •TBTF: expectation of rescue creates an implicit guarantee
- •Moral hazard: cheaper funding and weaker discipline encourage risk-taking
- •Farhi-Tirole (2012): bailouts breed collective, correlated moral hazard
Quick check
Which set of factors determines whether an institution is systemically important (a SIFI)?
In Farhi and Tirole’s (2012) "collective moral hazard," institutions
Connected topics
Sources
- Farhi, E., and Tirole, J. "Collective Moral Hazard, Maturity Mismatch, and Systemic Bailouts." American Economic Review 102 (1), 2012, 60-93.Shows bailouts induce collective, correlated risk-taking and excessive maturity mismatch.
- Basel Committee on Banking Supervision. Global Systemically Important Banks: Revised Assessment Methodology and the Higher Loss Absorbency Requirement. Bank for International Settlements, 2018.Indicator-based methodology for identifying G-SIBs and setting capital surcharges.