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Too Big To Fail

by Elaine Schwartz    •    Aug 15, 2011

Imagine for a moment that you are the CEO of a large bank. Offered the opportunity to participate in a risky business deal, you say, “Yes.” If the venture succeeds, you benefit. If it fails and threatens your bank’s survival, the government is there to experience the loss because your bank is “too big to fail.”

In a 2009 econtalk podcast, Gary Stern, past head of the Minneapolis Fed said that “too big to fail” distorts markets.  Explaining why, he said that once creditors expect that an institution will be rescued, no matter how risky its behavior, its demand curve shifts lower than it should be for that institution’s securities.  The result is “mispricing.” With borrowing less expensive, bankers have the incentive to engage in the risky behavior that creates systemic calamity.

Agreeing, Thomas M. Hoenig, President of the Federal Reserve Bank of Kansas City said, “…Without this market discipline provided by creditors willing to withdraw their funds when they suspect a bank of being unsafe, banks have an incentive to take excessive risks.” To people who say Dodd-Frank provides a solution, Dr. Hoenig disagrees. Instead, he believes that the only answer is breaking up large institutions.

Here, in a previous post, more is discussed about the problems of breaking up large banks.

The Economic Lesson
Whenever banking is discussed, someone always refers to Glass-Steagall as a benchmark.  Passed in 1933, Glass-Steagall is primarily associated with creating the FDIC and requiring banks to spin off their investment banking activities as separate firms. Repealed in 1999, actually, Glass-Steagall had gradually been unraveling since 1980.

An Economic Question: Economist Sam Peltzman once suggested that a solution to a problem sometimes creates the results you are trying to prevent. For example, seatbelts might lead to more accidents because drivers become careless. Might “too big to fail” be an example of the Peltzman Effect?

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