If a bank is "too big to fail," that kind of implies that it can't fail, right? Wrong. Banks that are "too big to fail" are certainly big, but that doesn't mean investors should blindly invest in their stock.
In this segment from The Motley Fool's Industry Focus podcast, hosts Gaby Lapera and Emily Flippen put this question to financials industry specialist Jay Jenkins. To understand what "too big to fail" actually means -- and what it doesn't -- Jay points to what happened to the shareholders of Citigroup (NYSE:C) and Bank of America (NYSE:BAC) during the last financial crisis. The shares prices of these two banks still haven't recovered from the crisis.
A transcript follows the video.
This podcast was recorded on Jun. 20, 2016.
Emily Flippen: Our next question is from Lindsay, our intern in Colorado. She asks, if a bank is labeled as "too big to fail," does that mean it's generally a safer investment?
Jay Jenkins: The short answer is no. I think anyone who has invested in Citigroup or Bank of America back around 2007 or 2008 would wholeheartedly agree with that. So, what does "too big to fail" actually mean? It means that the financial institution -- it could be a bank, it doesn't have to be. A lot of insurance companies are also too big to fail. It just means they're so interconnected with the global financial system that if they were to go bankrupt or cease operating, the entire globe would come to a halt in a financial sense. Payments wouldn't go through, companies would go to write checks and it wouldn't work, wouldn't make payroll. It could send a huge shock through the whole world.
The consequence of that is that governments are willing to step in and prevent these banks from, not necessarily failing, but from ceasing to operate. Citigroup is a great example. Citigroup is gigantic. It was a massive global bank, super interconnected all around the world. The financial crisis hit, and Citigroup started taking big losses, the capital ran out, they ran out of liquidity, and ultimately, what happened is, the government had stopped in, and forced Citigroup to raise new capital, diluting existing shareholders to an extreme degree. I don't have the number in front of me, but their stock today remains something like 90% below what it was back in 2006-2007 at its peak.
So, it's safer in the sense that if you have your deposits at one of these really large banks, those deposits are going to be pretty doggone safe, because the government is not going to let this bank fail. As an investor, it does not mean anything. Any bank can fail. If that happens, the brand Citigroup may survive, but existing shareholders are likely going to be wiped out or nearly wiped out as the company is forced to raise new capital, be it via the government or via private new money.
Gaby Lapera: The other thing to keep in mind is that this is a super hot-button political issue right now. [Presidential candidate] Bernie Sanders has definitely mentioned this quite a few times, if you're following anything on the debates or if you have a Facebook account. So, we don't really know what's going to happen. Maybe the government will provide regulation that causes the big banks to have to become smaller. There's potential for that. But really, the only way to safely invest in anything is to do your research. There's no 100% safe with anything, not even too-big-to-fail banks.