THE BLOG

Reflections on Too Big to Fail

03/26/2014 06:03 pm ET | Updated May 26, 2014

The scars of the financial crisis and Great Recession remain fresh in the public's and policymakers' psyches, and it is natural to search for the villain responsible for such distress. For many, the search is apparently over. In their eyes, a small group of "too big to fail" (TBTF) banks gambled recklessly with the future of the economy, knowing that taxpayers would ultimately be on the hook for any losses. The populist outrage against large financial firms is a natural corollary to this narrative.

Putting emotion aside, do the facts fit the accusations?

The TBTF problem occurs when there arises a widespread expectation that the government will provide a bailout to a bank in times of distress. If so, the bank will be able to borrow more cheaply, assume more risk, and operate with an inappropriate level of impunity. Notice that no bank can do this alone. TBTF is fundamentally driven by the expectation that the government will do the wrong thing.

The policy response to TBTF should be better policy, not crude measures like "break up the banks."

And it makes no particular sense to focus on large banks or other financial institutions. In looking at the history of government intervention, the American Action Forum's Satya Thallam documents that there is no particular pattern -- bailouts include large commercial banks, a hedge fund, a large insurer, carmakers, investment banks, Fannie Mae and Freddie Mac, and most recently, banks large and small. In almost every instance, there were institutions that looked and behaved nearly identically that did not receive assistance.

There is also no particular pattern on how any bailout was structured. Were bondholders sheltered? Equity holders? Counterparties? Over time, we have seen direct capital injections, equity stakes, loan guarantees, deposit guarantees, favorable loan terms, conservatorship, federal brokering of mergers and acquisitions; the list goes on.

And, finally, TBTF is not a "new" problem that requires a policy response. TBTF stems back at least as far as the bailouts of Continental Illinois and Penn Central. Certainly, the idea that the actions during the financial crisis, where many trace the crisis to the day Lehman Brothers was not bailed out, is a bit hard to buy.

In short, the idea that there is a small group of large financial institutions that use their status to coerce the American taxpayer is at odds with the logic of TBTF and the history of government intervention. Nevertheless, there have been efforts recently to quantify the putative advantage bestowed by TBTF. The basic idea is to compare the borrowing costs of TBTF firms (somehow identified) with those of non-TBTF firms (again, somehow identified). Unfortunately, trying to pin any funding differential on the TBTF phenomenon requires first correctly sifting through the funding differentials due to liquidity differences, historical performance, scope of business lines, and scale of operations. The thin chances of doing the latter correctly correspond directly to the low odds of measuring the former with any precision.

In sum, there is little reason to devote new policy efforts toward "too big to fail." Any empirical measure of it will likely be fatally flawed. Any focus on it as a new problem is at odds with history. Any narrow focus on large financial firms misses the scope of past efforts. And most importantly, past policy is the problem. New policy will not be any better until there is a way to effectively constrain future Administrations, agencies, and Congresses from inappropriate reactions at times of distress.

Too big to fail may be a problem. But it is no larger or smaller than the problem of good policy itself.