Evaluating "too big to fail"

Many commentators have argued that one of the key factors contributing to the financial crisis of 2008 was "too big to fail"--policy-makers' belief that certain institutions could not be allowed to fail because the consequences of their failure would be too disastrous. Here, the argument is simply that there is less incentive to avoid excessive risk-taking when someone else is picking up the bill. Ex post, of course, many financial institutions did get bailed out; not just in the US but in other countries as well. However, although the foregoing argument seems highly plausible (to me at least), one cannot be sure that financial institutions believed ex ante that they would in fact be bailed out. Here I want to review some of the evidence that they did.

The first kind of evidence is that people favourable to the banks were in Washington during the lead-up to the crisis. The two most prominent examples are Hank Paulson, who was Treasury Secretary between 2006 and 2009, and Tim Geithner, who was president of the New York Fed between 2003 and 2009. Paulson had been the CEO of Goldman Sachs between 1999 and 2006. Of course, by itself this fact is very weak evidence that he put his old institution's interests before the tax-payer's. However, there are a couple of additional reasons to suspect he might have done. First, Lehman Brothers--Goldman's biggest rival--was allowed to fail, yet AIG, which owed money to Goldman at the time, was bailed out. Second, on September 18th, 2008 (the day of the run on US money market funds) Paulson corresponded with Lloyd Blankfein, who succeeded Paulson as CEO of Goldman Sachs, more than with any other person in Washington except Ben Bernanke. Geithner has been accused by Sheila Bair, the ex-head of the FDIC, of putting the interests of bailed-out institutions' creditors before those of the US tax-payer. Similar accusations have been made against him by Neil Barofsky, the special inspector general of TARP and author of Bailout. Indeed, Geithner was ostensibly described by one Wall Street banker as "our man in Washington."

The second kind of evidence is that the largest Wall Street banks seem to enjoy a "too big to fail" subsidy. In particular, they face lower borrowing costs than their rivals because of the implicit government guarantee on their debts. According to a report by the Independent Community Bankers of America, of 15 studies that investigated the existence of the "too big to fail" subsidy, 14 found evidence that it existed, whereas only 1 did not, and that study was carried out by JP Morgan Chase. More recently, a study by Goldman Sachs found that the "too big to fail" subsidy has generally been small in magnitude, was largest during the financial crisis, but has since become negative. However, as the Bloomberg article reports, the economist Simon Johnson "said that Goldman Sachs' report proves the value of the too-big-to-fail subsidy because it shows the biggest banks enjoyed a large advantage during the financial crisis".

The third kind of evidence is simply the long list of bailouts that preceded those of 2008. Franklin National Bank was bailed out in 1974; Continental Illinois was bailed out in 1984; a large number of financial institutions were bailed out in 1989 following the S&L crisis; and several Wall Street banks were indirectly bailed out in 1994 when the Mexican government was loaned $50 billion to pay off its creditors after the peso crisis. In addition, LTCM's bailout in 1998 was organised by the New York Fed and was helped-along by easy monetary policy on the part of the Federal Reserve (though it was not taxpayer funded). Finally, a number of large non-financial institutions have been bailed out by the US government over the years. These include: the Penn Central Railroad in 1970, Lockheed in 1971, New York City in 1975, Chrysler in 1980, and the airline industry in 2001.