In market economies firms go bankrupt all the time. Bankruptcy courts handle the process quickly. And no one pays any attention except those with outstanding claims. What makes bankruptcy of financial firms different?
The answer usually offered by economists is that the collapse of financial firms threatens contagion or systemic risk: the spread of failure to other banks and firms that have no direct relationship to Lehman Brothers. Contagion is certainly a real possibility in commercial banking (the banks you and I deal with on an everyday basis) given how they are designed. The question economists and policymakers are wrestling with is whether contagion is also a possibility in investment banking. We seem to have two different answers in the Bear Stearns and Lehman Brothers cases. How is that possible?
Consider contagion risks in commercial banking. Commercial banks have ubiquitous relationships with other banks through the payments system, the system though which all of us pay our bills with checks or electronic payments. If a commercial bank failed and normal bankruptcy proceedings were applicable, everyone’s checking account in that bank would be frozen. In turn, everyone who had any relationship with the bank’s customers would have uncertain financial status and their banks would have uncertain market value. This is the contagion or systemic risk that policymakers invoke as a rationale for government intervention.
How could we deal with the possibility of investment failure affecting the payments system through contagion? One possibility is something called "narrow banking" in which the payments system is completely separate from savings and investment. Under narrow banking all the cash in checking accounts is either explicitly on hand or backed by investment in completely safe easy-to-liquidate Treasury bills. And all other savings and investments are at risk and not eligible for government assistance in a narrow banking system.
A second possibility, the system we currently have, is a marriage between the payments system and investment regulated and guaranteed by the federal government through the Federal Deposit Insurance Corporation (FDIC). In theory government monitoring allows banks to operate until their net worth is near zero. They then are taken over by the FDIC but no payments-system contagion occurs.
The advantage of the current system is that total investment can increase because all the money in checking accounts is invested rather than just sitting in the vault or in Treasury bills. The disadvantage is that customers no longer pay attention to what banks do with their money and assume that bank regulators and the FDIC figure everything out and prevent systemic risk.
Where do investment banks like Lehman Brothers and Bear Stearns fit into this picture? Some economists argue that because investment banks are not explicitly involved in the payments system (you can’t have a checking account at an investment bank) their bankruptcy is no different from that of Enron or your local hardware store. There is no possibility of contagion and the government should not become involved.
Other economists argue that the investment banks are integrally involved with each other through over-the-counter markets in financial derivatives, which are essentially insurance contracts tied to interest rates, currency exchange rates, and credit defaults. This is the investment bank equivalent of the checking account relationships between commercial banks. The central role Bear Stearns played in the over-the-counter derivative market is invoked by some economists as necessitating the federal guarantee of assets to facilitate the takeover of Bear Stearns by JP Morgan rather than bankruptcy.
Is Lehman Brothers different? There are several possibilities. First, the argument that investment banks have equivalent interrelationships to the payment system in commercial banking could be true, but some investment banks have a central role in that over-the-counter derivative system I described (Bear Stearns) while other investment banks (Lehman Brothers) have a peripheral role. In addition investment banks have had sufficient time to reduce their involvement in the derivative market with Lehman brothers as its financial condition worsened. Those two facts meant that normal bankruptcy would be possible and contagion fairly impossible in the case of Lehman Brothers but not possible in the case of Bear Stearns where the facts were different.
The second possibility is that investment banks have interrelationships equivalent to the payment system in commercial banking and the facts of the Bear Stearns and Lehman Brothers cases are equivalent. But allowing Lehman Brothers to enter bankruptcy did not result in contagion. Thus the Bear Stearns intervention was based on an incorrect theory and an illegitimate use of federal authority.
Both of those narratives can’t be true. Sorting out the truth of the two cases and the implications for banking regulation going forward is the essential task of economists and journalists. And if contagion is a real possibility, we should favor banking designs that wall off the contagion prone parts from the others to reduce the need for government intervention.