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The Myth of Too Big to Fail

Friday, October 30, 2009

When it comes to banking, size isn't the only thing that matters.

By Tim Fernholz
The American Prospect

Amid last fall's financial chaos, executives from Wachovia, at the time the fourth-largest commercial bank in the country, had bad news for their regulators: They were broke. Federal officials deliberated and decided Wachovia was so important to the economy that the government had to save it.

It was only the latest in a series of financial institutions that regulators had deemed "too big to fail." In the preceding months, the government had bailed out Fannie Mae, Freddie Mac, and Bear Stearns, and Congress had passed the controversial $700 billion bill to fund yet more financial-sector rescues. Some of the institutions, like the insurance company American International Group (AIG), weren't even banks.

When the news of Wachovia's failure first reached Federal Deposit Insurance Corporation (FDIC) Chair Sheila Bair, she wanted to liquidate the bank and cut into the pocketbooks of its investors -- as she had done with Washington Mutual, the largest U.S. bank failure ever, a few days prior. But Tim Geithner, then president of the New York Federal Reserve Bank, argued strenuously for Bair to invoke her agency's "too big to fail" exception and spend more money to cover the costs of the bank's sale. He worried another collapsing bank would only intensify the financial panic at a time when the government's hands were tied. (While the FDIC can liquidate a commercial bank like Wachovia, the Fed doesn't have the tools to shut down financial institutions, only the ability to prop them up with loans.)

Geithner, now the Treasury secretary, made the right decision at the time, but it was a terrible precedent to set. Sending the message that the government won't let large banks fail in a crisis gives them an unfair advantage over their smaller competitors. Worse, if bankers are rewarded for success and insulated from failure, there is little incentive for prudence and smart management -- the problem of moral hazard....(Remainder.)



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