July 18, 2011 8:34PM

Did ‘Too‐​Big‐​To‐​Fail’ Cause the Financial Crisis?

Last week I askedif Dodd‐​Frank had ended “too‐​big‐​to‐​fail” (TBTF) that is the perception that some banks (or other companies) are simply too big to be allowed to fail, and thus, must be rescued by the government. As this was an explicit purpose of the reform efforts, it seemed like a reasonable question to ask. Apparently even raising questions about the wisdom of Chris Dodd and Barney Frank is enough to throw some people into a fit.

In offering what I assume is meant as a rebuttal to my suggestion that the debt markets seem to indicate that the largest banks are currently enjoying a significant funding advantage over the smallest banks, which could result from “too‐​big‐​to‐​fail”, Matt Yglesias makes the quite accurate observation: “The thesis that looking at the debt market was a good idea sounded compelling to me, but if you look at the chart it shows clearly that during the peak bubble years large banks didn’t have a funding advantage. The large bank funding advantage was a consequence of the crisis, not a cause of it” 

Matt stumbles onto a critical point here. If we believe debt spreads can tell us something about “too‐​big‐​to‐​fail” then the debt markets during the housing crisis did not believe, or behave, as if the largest banks, as a whole, were “too‐​big‐​to‐​fail”. In fact the largest banks didn’t start enjoying a funding advantage until after the assisted sale of Bear Stearns. This TGTF funding advantage reached its peak in the Spring of 2009, after the bailouts of Fall 2008. I think the fact that both Bear and Lehman counter‐​parties started a slow “run” weeks before either failed is also evidence that the markets didn’t see these institutions as TBTF. I think its fair to say that what regulators were actually trying to do was stop market discipline, not replace a lack of it. Also why would market participants try to insure against the failure of a company (often via a credit‐​default‐​swap) if they believe such a company was going to be bailed‐​out. It would appear to me that market participants were, unlike regulators, taking actions to minimize the harm from the failure of a large bank. 

What does all this amount to? It suggests to me that “too‐​big‐​to‐​fail” is ultimately a political/​regulatory creation and not the result of the market. Which also suggests it can only be stopped with a political solution (stopping the regulators from being able to do bailouts). Again it seems as if one of the basic assumptions of Dodd‐​Frank, that TBTF drove the crisis, is false. No wonder the Act itself has done so little to fix our financial markets.