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Who Invented TBTF (Too Big to Fail)?


The tangled history of an idea nobody loves.

Most controversial issues have people on both sides, and we know more or less why they disagree. People who want more gun control think it will reduce violence and fear. People who don't want more gun control think it will lead to more crime and government disrespect for citizens. We can trace the history of the dispute and find people on both sides of the issue.

TBTF (too big to fail) is different. Everyone is against it. Everyone agrees that institutions insulated from failure behave recklessly, and that government supporting the big firms in an industry creates a tilted playing field that discourages innovation, independence, and human-scale institutions. It's expensive, threatening to bankrupt many governments. It's revolting to witness governments bailing out big banks - the ones with those extortionate overdraft fees and deceptive credit card charges - and rich people while raising taxes and cutting programs to pay for it. Private profits and socialized losses offends our sense of fairness as it robs our wallets.

So why are we stuck with this unloved idea? Most people have a vague sense that the banks grew big while regulators weren't paying attention, until one day we woke up and discovered some were so big that their failures threatened the economy. If anyone had any doubts about this, the disaster following the Lehman bankruptcy proved it, and Lehman was only the twelfth largest bank in the US. But if that's true, why haven't we broken up the large banks? The answer to that question is that TBTF has an entirely different history that you have to understand in order to see what the future is likely to bring.

The story begins in 1984 with the failure of Continental Illinois Bank. The seventh largest bank in the US at its peak, it had made many imprudent business loans, especially to oil and gas companies hurt when energy prices declined, and overpaid for some acquisitions (notably Penn Square Bank) that had made even worse loans. It had some other bad exposures to developing countries and it guessed wrong about interest rates. As a result, the government had to take it over. The good news is that CI didn't have a lot of insured deposits; it funded itself mostly by taking brokered deposits too large to be covered by FDIC insurance, and by issuing notes and bonds. Another bit of good news is that it had a pretty simple corporate structure and balance sheet.

There are two basic ways to resolve a failed bank. The simplest way is to shut it down, auction off the assets, and pay off the creditors in order of seniority. If there isn't enough to cover the insured deposits, the FDIC writes a check for the difference, and if necessary, raises the insurance premium on other banks to recoup the loss.

The downside of that approach is that you sacrifice the going concern value of the bank. In addition to the assets on the balance sheet, a bank has value due to its branch network and business relationships. Perhaps the assets would fetch $50 million less than the liabilities at auction, but another bank is willing to absorb that $50 million loss in order to acquire the intangible assets of the bank. Moreover, the failed bank's assets will always be worth more to a financial institution experienced at managing distressed loans than the assets will fetch at auction.

So the second way to resolve a failed bank is to find another bank willing to take it over, possibly with some cash thrown in by the government - but less cash than a liquidation would cost. Not only does that save the FDIC money, but it also means less turmoil among bank customers, counterparties, and employees. However, there is a downside to this as well: It takes longer and is more complicated than a liquidation, and the government has to support the failed bank while searching for an acquirer.

Traditionally the government would opt for a liquidation unless a willing acquirer could be found before the troubled bank failed. But twice before CI, the FDIC had supported a failed bank by guaranteeing all creditors - not just the insured depositors. That was a risk; if the bank had to be liquidated anyway, the government was on the hook for a larger loss. The potential reward was that the extra time bought by the guarantee would be enough for a win-win deal to be structured. In both of the first two instances, the gamble paid off.

For CI, the government decided to roll the dice for a third time. That decision has been criticized, and it may have been imprudent. It certainly didn't work out, and there were some other arguable missteps in the FDIC's handling of CI. In the end, it cost the federal government seven years and $1.1 billion to resolve CI. Very little of the going concern value was preserved. An immediate liquidation would have been costless to the FDIC, CI's assets would have easily covered the insured deposits, and after-the-fact estimates suggest there would have been six follow-on failures of small banks, at no cost to the FDIC.

Even as events were unfolding, people were criticizing the FDIC. Congressman Stewart McKinney charged that the FDIC had guaranteed uninsured deposits and bonds because it thought CI was "too big to fail." The term had been used before, but this is what made it a household term. The important point is that McKinney did not like TBTF; he was accusing the FDIC of something everyone agreed was wrong. The FDIC denied the charge and said that it was acting to minimize taxpayer losses.

In the heat of the moment, lots of people said lots of different things. One major confusion is that the Fed had also gotten involved in the situation, extending discount window loans and arranging loans from other banks to help nurse CI along. But as Paul Volker (the Fed chair at the time) emphasized, these things were done with the belief that CI was not insolvent, and both direct Fed loans and Fed brokered loans were well collateralized with high-quality, liquid assets. The Fed supported CI to protect the banking system, but it took no significant risk to do so. The FDIC took risk, but with the intention of protecting taxpayer funds, not to protect the banking system. And neither one thought CI's size was particularly important. (The previous FDIC guarantees of uninsured deposits were much smaller banks, and the Fed supports banks large and small alike, as long as it considers them solvent.)

So no one thought CI was TBTF. No one advanced risky bailout funds in order to protect the banking system. No one wanted to allow TBTF. Congress passed the Federal Deposit Insurance Corporation Improvement Act of 1991 in order to prevent TBTF.

But the 1991 Act had a more complex effect. During the seven years of wrangling, a prohibition on TBTF rescues got watered down into strict conditions on TBTF rescues. It worked to some extent. In the seven years between CI and the 1991 Act, most bank rescued uninsured depositors took losses in less than 20% of bank failures. From 1992 to 2000, that percentage jumped to 65%. It was not all the result of the Act; we had a major banking crisis in the second half of the 1980s and regulators were nervous about a total collapse, while the 1990s were a little calmer. It's important to note that the choices of which banks to bail out and which banks to liquidate were not based on size.

For some reason, however, the idea grew up so that TBTF was part of official US bank policy, even though nobody thought it was a good idea. Some of that might have been fanned by Fed involvement in the rescue of hedge fund Long-Term Capital Management in 1998. But the Fed only brought creditors together to forge a voluntary pact to protect each other, no government money was involved, and in the end, no losses were taken. It's true that the Fed was concerned that LTCM might be too interconnected to fail, but no one considered that an excuse for putting taxpayer money at risk.

Fast forward to March 2008. The Fed very reluctantly agreed to provide some non-recourse funding and guarantees to JPMorgan (NYSE:JPM) to encourage it to purchase Bear Stearns because it was concerned about the potential effects on the financial markets of Bear's bankruptcy. While this is farther than the Fed had gone in the past, it was well short of a bailout, and it was based more on the confusion from the speed of Bear's decline and the complexity of its dealings than on a determination that large banks cannot fail. The FDIC is not involved. Then in September, Lehman is allowed to fail.

So in the entire history of the idea up to September 2008, there really is no TBTF. People accuse other people of it, and explain how bad the idea is, but no one supports it, and it is never policy. Creditors and uninsured depositors of some banks are bailed out sometimes, but not because the banks are big, or interconnected, or systemic.

After the failure of Lehman, of course, was the gigantic bailout package. But it wasn't for big banks; it was for hundreds of banks, large and small. And it wasn't aimed at protecting individual institutions, but at preventing a simultaneous systemic collapse. It was a terrible idea at the time. It was only passed on the second attempt by extraordinary political arm-twisting, and many of the proponents have since come to regret it, some bitterly. The chance of another bailout anytime soon is very slim.

So TBTF is a myth. It is the monster under the bed, the dragon on the edge of the map. We never had it, and we certainly do not have it now. The Fed will act aggressively to protect the financial system, but it will not bail out large banks, nor any banks that it believes to be insolvent. The other bank regulators will sometimes protect uninsured depositors and creditors, but because they think it will save money, not because the bank is big, or interconnected, or systemic. There's no shortage of real financial issues to worry about, and plenty of controversies with people on both sides. So don't spend time worrying about made-up issues about which everyone agrees.
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