Too Big to Fail: A Thorn in the Side of Free Markets

This paper examines the essential features of too big to fail (TBTF) regimes. These regimes justify themselves on the basis of the high and socially unacceptable costs associated with their exit from the market. At the same time, a TBTF regime affects the foundations of an orderly market economy by undermining the market function of natural selection. The implicit state guarantee linked with TBTF for large and systemically important financial institutions produces negative welfare effects and creates incentives for these establishments to grow beyond their optimal size. However, the state guarantee cannot explain the existence of "mega-banks".