No Bank Is Too Big to Fail

March 15, 2013

During the Great Depression, 9,000 of the nation's 25,000 banks failed as depositors as everyone rushed to withdraw their funds amidst great panic about the liquidity of banks. The Federal Deposit Insurance Company (FDIC) was established in June 1933 to ensure deposits, resolve banks that fail and reduce the likelihood of another run on the banks. Subsequent actions by the FDIC created banks that were "Too-Big-To-Fail." The failure of large banks can cause instability but the FDIC must allow them to occur, say James R. Barth, the Lowder Eminent Scholar in Finance at Auburn University, and Apanard Prabha, an economist in the Financial Research group at the Milken Institute.

  • In 1984, the FDIC bailed out Continental Illinois National Bank & Trust, the seventh largest bank at the time, because the bank was essential to providing adequate services to the community.
  • The FDIC infused $1 billion into the bank and created the belief that certain banks of bank holding companies are too-big-to-fail.
  • The Savings and Loans crisis during the late 1980s cost $100 billion and the recent housing market bubble and meltdown from 2007 to 2011 created $90 billion in losses.

Before 1950, if a bank was failing, the FDIC could either liquidate a bank and pay off insured depositors or arrange for the bank's acquisition by a healthy bank. After 1950, the FDIC was allowed to infuse funds into banks to address any temporary funding problems.

  • By the time the housing bubble burst, failure of large banks was not considered a plausible option given the perceived systemic risks.
  • Because most banks are held by holding companies, bailouts are typically aimed at holding companies, which, after the Glass-Steagall Act was repealed in 1999, were also involved in investment banking, market-making and full-service asset management.
  • When the housing bubble burst in 2007 and banks throughout the economy were holding toxic mortgage-backed securities, the Troubled Asset Relief Program spent $245 billion on 707 banks -- 86 percent of the funds went to 20 big banks.

Banks do not need more regulators. To ensure that catastrophic financial contagion like the United States experienced in 1930 and 2007 does not happen again, regulators need to enforce existing regulations instead of creating new ones. Policymakers must allow big banks to fail and the FDIC's new liquidation authority to wind down banks without huge injections of taxpayer money.

Source: James R. Barth and Apanard Prabha, "Resolving Too-Big-To-Fail," Mercatus Center, March 7, 2013.

 

Browse more articles on Economic Issues