Economic Crisis Is a Failure of ‘Too-Big-to-Fail’

Published June 18, 2010

Manhattan Institute Senior Fellow Nicole Gelinas recently visited Chicago, where the author of the recently published and well-received book After the Fall: Saving Capitalism from Wall Street discussed the causes of and solutions to the ongoing economic slowdown. The discussion resulted in a nine-minute Heartland Institute video (at http://www.youtube.com/watch?v=dnOYmKPNlqs) and this condensed version of her comments:

“The government has not served the proper role as the rules-creator and -enforcer—the creator of a level playing field. Instead it has been an arbitrary rescuer and bailer-out of these financial institutions, and that is not a consistent free-market system. That is a system of state capitalism that supports one industry—the too-big-to-fail financial industry—and that is what failed.”

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“One of the biggest problems we face as we supposedly come out of the 2008 financial crisis is that we do not have a system of market discipline for the financial industry. This is something we have not had for 25 years. We have an entire sector of the economy that has gradually figured out a way to be immunized from consistent, predictable market losses. It has done that by making sure a large, complex firm cannot fail without taking the rest of the economy down with it.”

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“One thing we learned coming out of [the Great Depression] in the 1930s was we cannot have banks fail in a disorderly fashion. A bank that takes deposits from the public can’t go out of business, because this causes panic.

“On the other side, the government, to its great credit, understood that you could not have banks not fail. You had to have a way for markets to discipline banks, otherwise they would be even more reckless than they had been. . . . After a few fits and starts, they came up with an elegant solution: The FDIC, which said only small depositors—if you’re a grandma with a few thousand dollars in the bank— are protected, but all of the big bondholders, big, sophisticated lenders to the bank, will not be protected.

“So the FDIC would seize the banks, protect only the little people, and the big guys would lose their money. That meant you had orderly bank failure, market discipline of banks, without taking down the rest of the economy.”

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“I think the most important break in the 1980s . . . was the evolution of the commercial banking system that allowed it to start to escape market discipline. . . . What happened in the ’80s, you had the creation of the first too-big-to-fail bank right here in Chicago. This was a bank called Continental Illinois, the eighth-largest bank in the nation. . . . You had the upper echelons of the executive branch saying we can’t let this bank fail through the normal processes. We’re going to protect all of the bondholders to the bank.

“Why did they do this? The bank had been kind of a pioneer in creating a way of doing business that added too much risk to the economy if it were to fail. On the commercial banking side, they did not hold loans on their books for 30 years. Rather, they purchased securitized loans from another bank.

“What did this do? It meant they really weren’t sure what was in these loans. The bank that sold them to them had no real incentive to care what was in these loans, because they had just sold them off for a fee before that bank had gone bankrupt as well. And it meant that you are introducing the kind of panic that occurs in stock markets into the credit markets. You’ve got securities made up of loans, but they act like stocks. They’re just as vulnerable to stock market panic.

“That meant after that, if you were lending money to a big bank you knew your money was not at risk. That’s how you get a debt crisis built up over 25 years. It is a government subsidy of debt to the financial industry.”

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“We are not stuck with ‘too big to fail’. This came about because of certain things we did for 50 years that worked well that we stopped doing in the 1980s. The only thing we have to do is go back to doing them. . . .

“You have to go back to consistent limits on borrowing, so government no longer says this type of investment is risk-free, it’s Triple A-rated, so you barely have to put any capital behind it.

“Capital is only non-borrowed money. Why do you need that? Because it absorbs losses. If you’ve got an asset that is paid for with 100 percent borrowed money—that is, no capital—it cannot decline by even a percentage point without bankrupting you. So you’ve got to have some non-borrowed capital, 10 percent; pick your percentage. . . .

“What we’ve done for 20 years is say things that the government perceives as not risky need no capital down, almost. On things the government perceives as risky, you have to have high capital. So what did the financial industry do? [It] put all of its money in Triple A-rated securities. The government told everyone to make the same mistake all at once, and the economy cannot withstand that.”