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Who Invented TBTF (Too Big to Fail)?

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The tangled history of an idea nobody loves.

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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.
No positions in stocks mentioned.
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