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Measuring and Managing Liquidity Risk by Francesco Fede, Antonio Castagna

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3

Too big to fail

3.1 INTRODUCTION

In Chapter 2 we often referred to financial systemic risk and the related meltdown in the case of default by one or more banks considered “too interconnected” to be allowed to fail.

This topic deserves great consideration because it is strictly linked to the issue of moral hazard. As stated previously, without symmetric and complete information on the financial system, moral hazard can arise as insolvent banks may act as merely illiquid ones by underinvesting in liquid assets and gambling for assistance. In the literature many authors have written about the moral hazard and the social cost related to saving insolvent institutions, and made clear they were against any form of support or rescue for them.

We pointed out that in practice it is really difficult for central banks and supervisors to distinguish ex ante between illiquid and insolvent institutions. Nevertheless, we have already verified what can happen when a systemically important financial institution (SIFI) is allowed to fail: systemic meltdown and financial turmoil are not remote warnings to list in academic papers, they may become the worst and most dramatic side of a financial crisis.

Box 3.1. Systemic risk

The notion of systemic risk is closely linked to the concept of externality, meaning that each financial player individually manages its own risk but does not consider the impact of its actions on the risk to the system as a whole. As a consequence, the aggregate amount of ...

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