In an April speech to the Economic Club of New York, the chairman of the Federal Deposit Insurance Corporation, Sheila Bair, took a stand on one of todays most pressing economic questions. The idea that certain financial firms were too big to fail, she said, should be tossed in the dustbin. Congress should pay attention. Since the early 1980s, Washington has increasingly refused to let the largest or most complex financial institutionsthe expression too big to fail includes bothgo under in a predictable manner. Instead, it has taken extraordinary actions to rescue and protect them, lest their failure inflict broader harm on the economy. By sheltering the lenders to these firms from market discipline, it has encouraged the financial industry and its consumers debt load to grow to unsustainable size. Yet even after the Wall Street collapse, the Obama administration, far from following Bairs advice, is pushing the too big to fail policy even further. This course will exact a terrible cost. For our economy to thrive, too big to fail must die.
Until the early 1980s, it was generally assumed that failure was a possibility for financial institutions, along with losses for investors who lent to them or held shares in them. Sensible regulation underpinned the assumption. Back in the mid-1930s, the trough of the Great Depression, the federal government created a way for commercial banks to go under without catastrophically damaging the broader economyas had happened earlier in the decade, when customers, panicked about banks health, rushed to withdraw their money, making lending dry up completely. The feds instrument was the very institution that Bair now heads: the FDIC, a government-chartered body that insured small depositors funds so that they wouldnt panic. With mom-and-pop depositors protected, the FDIC could then take over failed banks and wind them down in a predictable way, ensuring that shareholders and uninsured lendersthat is, depositors whose accounts exceeded FDIC limits, as well as bondholderstook their lumps. (The FDIC covered only commercial banksthe storehouses of the economys vital money and credit suppliesnot investment banks, which failed through the normal bankruptcy process.)
Fifty years of policy died in 1984. That May, the nations eighth-largest commercial bank, Chicagos Continental Illinois, found itself in deep trouble. Like any enterprising company in a capitalist society, it had exercised its right to establish a competitive edge and pursue greater profitswith a corresponding risk of failure, which had now struck. Continentals biggest error was how it paid for its investments. All banks use depositors money and other sources of funding to make loans and other investments. But beyond using funds from FDIC-insured small depositors and other stable, long-term lenders (such as bondholders), Continental relied more than most banks on short-term, uninsured lenders from around the globe, particularly large depositors. Global corporations and other investors often park their money overnight or for a few weeks at a time in bank accounts that offer slightly higher rates because, once theyve exceeded the FDIC limits, they carry risk. For a lender who doesnt mind that risk, these short-term, uninsured accounts are attractive, since he can pull his money at any time if he needs cash, finds a better rate elsewhere, or perceives a new danger. For the borrower, like Continental, however, that ease of withdrawal made the funding source perilous. A sudden panic could leave the accounts depleted and the bank without money just when it needed it most.
Continentals reliance on uninsured short-term lenders was especially negligent because it had invested heavily and unwisely in speculative loans, meaning that a drop in its lenders confidence was almost inevitable. Only long-term lenders or guaranteed depositors, who wouldnt yank their money out immediately in a crisis, could insulate the bank in such a situation. As soon as rumors swirled that Continentals investments were going bad, the short-term global lenders predictably pulled their funds. Fear of Continentals books then metastasized into worldwide fear of all American banks books. The reason: many of those banks had also started to rely on uninsured short-term lenders for funds, and the lenders often didnt make distinctions among individual banks.
After taking some modest and ultimately unsuccessful steps to calm the panic, the U.S. government did something radical. The Federal Reserve and the FDIC, in a race to save Continental and thereby sustain confidence in the nations banking system, the New York Times reported, pledged that no uninsured depositor or other lender, including bondholders, would lose money should the bank collapse. In July, to avoid a major financial crisis, as the Times put it, the Reagan administration outright nationalized the hobbled bank, with the FDIC taking 80 percent ownership and responsibility for its bad loans. The era of too big to fail had begun.
The break from normal practice divided the administration. Treasury Secretary Donald Regan found the intervention outrageous: We believe it is bad public policy, would be seen to be unfair . . . and represents an unauthorized and unlegislated expansion of federal guarantees in contravention of executive branch policy, he wrote to his colleagues. But the White House, by offering its quiet support to the Fed and the FDIC, plainly agreed with their compelling argument that the alternative was to risk a systemic crisis in the financial industry.
Federal Reserve chairman Paul Volcker told Congress that the decision to protect uninsured lenders of a private institution from the consequences of a freely assumed risk wasnt meant to set a precedent. But the federal comptroller of the currency, which regulates banks, made clear that a shift in policy had taken place, telling Congress that none of the nations top 11 banks would be allowed to fail. Small banks were apoplectic. Jokes flourished about investors not wanting to put money into the nations 12th-largest bank. How often and to what extent can the government, and in turn the taxpayers, prop up any institutions that are neither the nations best or brightest? wondered the Independent Bankers Association of America.
The too big to fail principle persisted during the savings-and-loan crisis of the late eighties and early nineties, when Washington saved uninsured lenders to big banks wherever it saw a risk to the broader system, letting uninsured lenders to smaller banks languish. In the summer of 1991, Fed chairman Alan Greenspanjust a few years after saying (as a libertarian private-sector economist at the time) that he wasnt even a great fan of deposit insurancereminded lawmakers of the post-Continental stance that there may be some banks, at some particular times, whose collapse and liquidation would be excessively disruptive.
Gradually, lenders to big banks understood that their money was no longer at risk. And the banks realized that the bigger and more complicated they got, the safer they would be from market disciplineand so they became. Of course, the financial industry changed in response to many other forces, too, including shifting market demand, global competition, and increasing investment in the stock market. But well never know exactly how great a role government protection played in driving finances transformation, since government subsidiesand thats what too big to fail amounts toalways distort the valuable information that markets provide.
Nearly a decade and a half after the government rescued Continental Illinois, too big to fail expanded beyond commercial banks to other parts of the financial world. The catalyst: the 1998 collapse of a small Connecticut hedge fund, Long-Term Capital Management. Long-Term, a money manager for wealthy investors, used exotic, often unregulated, financial instruments called derivatives to bet on the up-and-down movement of certain securities and financial markets. In the summer of 1998, after four years of good profits, the firm miscalculated badly. Like Continental, it had exercised its American right to take risksand it screwed up.
It couldnt afford to. Long-Term had made $125 billion in investments, even though its own shareholders had given it only $2.3 billion. It had borrowed the rest$53 for every dollar it had in hand. But that wasnt all: through its derivatives, Long-Term magnified its potential obligations to a scarcely conceivable $1.25 trillion. There would be no way for the hedge fund to pay its debts should anything go wrong, and now it had.
Too big to fail played a key role in bringing the crisis about. The source of Long-Terms breathtaking borrowing was none other than the big banks, both commercial and investment. Lenders to the commercial banks had known that the government implicitly protected them, and thus didnt worry much about what the banks were doing with their money, including extending so much credit to the hedge fund. The investment banks had to keep up with the commercial banks as competition intensified and their profit margins shrank, so they had poured their money into Long-Term, too.
Long-Terms pending collapse represented a huge risk to the rest of the financial worldan even greater risk than Continentals hadand an incalculable one. Nobody knew which of the worlds banks, brokerage firms, and hedge funds might be left owing or might be owed billions of dollars if Long-Term declared bankruptcy. And this opacity of exposure wasnt Long-Terms only threat to the financial system. The firms enablers had lent it money on a short-term, often overnight, basis. The collateral for the loans was Long-Terms various investments, meaning that in a default, the lenders could swoop in, seize the collateral, and dump it into the global markets. This forced selling would instantly drive down the price of everything from junk bonds to mortgage securities, causing problems for other firms that had borrowed against similar collateraland for the broader economy.
Long-Term couldnt fail, then, regulators determined. Under the New York Feds supervision, the banks and investment firms that had lent the fund enough money to push the financial world to the precipice now pulled the company back. They infused $3.6 billion into Long-Term and took 90 percent ownership. Lenders to Long-Term lost nothing. Now, lenders to all complex financial firms enjoyed the same implicit protection from normal failure mechanisms that the biggest commercial banks had.
The new precedent was stunning. Scarcely a half-decade earlier, Greenspan had said he couldnt imagine that the U.S. government would ever bail out a securities firm. In 1990, a prominent American investment firm, Drexel Burnham Lambert, had declared bankruptcy and the financial world survived; in 1995, just three years before the Long-Term rescue, a large British-based investment bank, Barings, had gone bankrupt, also with no horrific repercussions. But since then, the financial world, through the expansion of unregulated derivatives, had become more complex and thus vulnerable to contagion from one firms failure, putting the economy at risk, too.
As the dust settled from the Long-Term debacle, Washington tried to backtrack, pointing out that no taxpayer money had been used in the bailout. But Greenspans public statements and his rattled demeanor during and after the crisis made clear that the Fed would have used government funds if the banks had refused to help. Uninsured lenders everywhere recognized that if the government protected lenders to a hedge fund, then it certainly wouldnt let an investment bank collapse. Lenders critical role in disciplining the financial systemby refusing to lend to overly risky institutionswas gone.
From that absence sprang the current financial crisis. Lenders had every reason to lend freely and carelessly to financial firms, letting them pile up cheap debtwhich they did, leaving themselves little room for error if even a few of the investments that they supported with the debt went sour. In turn, the firms lent too much to American consumers. Between 1980 and 2008, total debt in the economy more than doubled as a percentage of gross domestic product. Massive amounts of cheap debt helped create the asset bubble that burst, starting in 2006, and took the global economy with it.
By the time the crisis intensified in 2008 with the foundering of Bear Stearns, Citigroup, and AIG, the governments rescue of these too-big-to-fail firms wasnt surprising. True, the feds declined to bail out Lehman Brothers, letting its lenders take losses. But the panic after Lehmans bankruptcy seems to have convinced officials that permitting losses was a mistake. By the end of last year, the government, through a temporary new FDIC program, was offering to guarantee virtually all new lending to banks.
In every one of these casesContinental, the savings and loans, Long-Term, the current crisisthe governments immediate response was understandable. If it had permitted disorderly failure in either 1984 or 1998, the short-term consequences would have been dire, bringing the risk of a deep recession as financial firms and instruments failed and survivors tightened lending. Similarly, it was economically impossible for President George W. Bush to force lenders to Bear Stearns, Citigroup, and AIG to take losses when there was no consistent, orderly process through which they could do so without risk to the economy. Uninsured depositors and other lenders had come to expect bailouts over the decades and had acted accordingly, running risks that left themselves, and the economy, vulnerable to systemic catastrophe. A sudden shutdown of an inadequately regulated financial industry could have resulted in a depression.
Whats unforgivable is the governments response after each crisis. After their ad hoc rescue of Continental Illinois, regulators and elected officials should have presented it to the public as harsh evidence that the old regulations to wind down bad financial institutions had stopped working, necessitating credible new ones that would let uninsured lenders to banks know that they risked warranted losses. Such enforcement of market discipline might have prevented Long-Term Capital Management from happening 14 years later. After it did happen, the government, once again, should have instituted regulations to protect the economy from both disorderly failures and exploding financial instruments. Instead, we have had two and a half decades of punting on the key regulatory questions.
Today, after the most recent and destructive round of explosions, the governments response threatens to be more of the same. The Obama administration claims that it wants to create a way for bad financial firms to fail. Yet in its June financial-regulatory proposal, it formalizes too big to fail, giving the Treasury new power to stabilize a failing institution . . . by providing loans to the firm, purchasing assets from the firm, guaranteeing the liabilities of the firm, or making equity investments in the firm. The proposal says nothing about making sure that bondholders and other uninsured lenders take losses.
Reintroducing a predictable, credible way for lenders to financial firms to take losses when failure strikes would go a long way toward protecting the economy from speculative excesses. Market forces, coupled with overdue new rules for inadequately regulated financial instruments, would have a better chance of reducing reckless risk-taking before it got out of control.
As a first step, the government should create an FDIC-style conservatorship for failed big or complex financial institutions. A new kind of bankruptcy could come into play in such a process, says University of Texas business-law professor Jay Westbrook. It might keep some lenders (and trading partners on derivatives) from seizing their collateral immediately and selling it. This would reduce the possibility that instant sales of billions of dollars worth of securities would destabilize the financial system.
In another elaboration of the conservatorship idea, economists R. Glenn Hubbard, Hal Scott, and Luigi Zingales have proposed an elegant FDIC-managed system that would begin by splitting failed financial firms in two. One new entity would take over the toxic assets that caused the firms problems. This bad bank would also bring the failed firms lenders with it, and the lenders would take losses based on the collapsed value of the assets. The other new entity, no longer weighed down by the bad assets, could meet the original firms remaining obligations and raise new funds. It could then free itself from government administration, as in any corporate exit from bankruptcy. Lenders to the original failed firm, now lenders to the bad bank, would receive stock in the restructured firm, sharing in its future profits, just as lenders to an ordinary bankrupt firm can.
However the arcane details take shape, the key factor in imposing market discipline on the financial world is credibility. Lenders to big banks and other financial firms must be made to worry that their money really is potentially at riskthat the feds wont keep stepping in to save them. If credibility isnt soon established, Washingtons actions will have created a monster, stoking more reckless debt creation at a time when debt has already reached a staggering and record 350 percent of GDP. Witness how quickly banks were able to borrow money earlier this year from private lenderssometimes without the FDICs new emergency guarantee. The government heralded the loans as evidence that lenders were regaining confidence in the financial sector. They werent. Lenders merely had confidence that Washington would stick to its policy of bailouts for tottering financial companies.
Too big to fail imperils the economys long-term health in other ways. If big or complex financial firms keep their state subsidy, theyll continue to divert lenders money away from other, perhaps more deserving, industries. Why lend money to Cisco when you can lend it to Citigroup risk-free? Further, failure is necessary in a free market, since it improves economic efficiency. When a company fails, a more successful firm can buy its good assets, releasing them from incompetent management. Failed firms workers can likewise find more useful outlets for their labor. Even people who made the mistakes that led to a firms failure can start anew. Vitally for the economy, failure helps ensure that bad ideas die, so that government and private resources arent wasted on a business model that doesnt work.
If real reform doesnt happen, get ready for a fearsome certainty: that markets will eventually correct our unsustainable financial system. They have tried to do so several times over the decades by punishing firms like Continental, Long-Term, and, most recently, Citigroup, as well as the lenders who financed them. The government thwarted these necessary corrections at every turn, bailing out the reckless and their enablers. But the price of maintaining our untenable system keeps growing, and eventually the government wont be able to pay the bill. The multitrillion-dollar price tag attached to the governments current endeavors already endangers the nations fiscal health. A decade from now, failing financial firms could take the credit of the U.S. government right down with them.
Nicole Gelinas, a City Journal contributing editor and the Searle Freedom Trust Fellow at the Manhattan Institute, is a Chartered Financial Analyst and the author of the forthcoming After the Fall: Saving Capitalism from Wall Streetand Washington.