H.S. Malek

English

Research Papers in Economics

A
few months ago, as I was
researching the size distribu-
tion of U.S. commercial banks,
I ran across Too Big To Fail in our Bank’s
library. The book, written by Gary Stern
and Ron Feldman of the Federal Reserve
Bank of Minneapolis, addresses one of
the more important issues facing policy-
makers today: how to deal with large
corporations that have been deemed so
important to the U.S. economy that the
government doesn’t dare let one go
bankrupt.
The term “too big to fail,” hereafter
referred to as TBTF, has been around
since at least the mid-1970s. But it didn’t
enter common parlance until 1984,
when Congress held hearings on the
financial problems of Continental
Illinois Bank. The banking sector, of
course, is vital to the American economy
— and fears that the collapse of one
institution would lead to the fall of oth-
ers has inspired much TBTF policy.
Indeed, because of past bailouts, many
investors now believe that large banks
are subject to implicit government pro-
tection. Such protection may produce
short-run stability, but the moral-hazard
problems that arise from TBTF policies
can produce major net costs. “While the
fiscal flows of the savings and loan
bailout in the United States equaled
$150 billion, lost output from the sav-
ings and loan crisis — largely attributed
to moral hazard and poor resource allo-
cation — was on the order of $500 bil-
lion,” Stern and Feldman write.
In essence, TBTF banks become 100
percent insured by the government,
warping price mechanisms within finan-
cial markets. The higher premium that
otherwise would be demanded by risk-
averse depositors is depressed by
implicit government insurance, and
TBTF banks enjoy a government 
subsidy for their risk-taking. Market 
discipline evades the TBTF bank, 
leading to suboptimal performance.
Independent of failure, there is an 
inefficient use of  capital — and when
you add a bank bailout to the mix, the
costs can skyrocket.
In  today’s world of increasing bank
consolidations there is some urgency for
formulating good policy. Stern and
Feldman are cognizant of the serious
obstacle posed by systemic risk in cor-
recting the present distorted incentive
structure. Accordingly, they couple ways
to preempt contagion and limit creditor
losses with a credible commitment to let
big banks fail.
Preempting Contagion
In  Chapter 5, titled “Why Protect
TBTF Creditors?”, Stern and Feldman
present potentially surprising argu-
ments about bank runs. Historically,
they claim, many bank failures have not
produced the widespread ripple effects
one might have expected. “Brief, rapid
disruptions weed out poorly run or
weak competitors and discipline banks
as to future exposures. Banking panics
are simply a form of the invisible hand,”
Stern and Feldman write. Still, they
acknowledge that many people will not
be convinced that intervention may be
unnecessary. So in Chapter 10, titled
“Reducing Policymakers’ Uncertainty,”
they introduce targeted reforms aimed
at lessening the chances — and costs —
of contagion.
One of these potential reforms is sce-
nario planning. By simulating bank fail-
ures, bank supervisors can examine the
implications of cross-firm exposure for
creditor solvency. Then they can test a
wide range of resolution options, and
pick the one that minimizes coverage
provided to uninsured creditors without
creating excessive financial instability. 
“Almost as important as the planning
itself is the disclosure of scenario plan-
ning to bank creditors,” write Stern and
Feldman. The mere fact that such plan-
ning is taking place would inform credi-
tors that the wisdom of TBTF policies 
is being questioned and that alternatives
are being considered. This would likely
make those creditors more vigilant in
monitoring banks’ activities.
What’s more, the suggestion for
greater transparency in scenario plan-
ning “reflects lessons we take away from
the experience of monetary policy,”
Stern and Feldman write. “During the
period in which the U.S. central bank
established and maintained greater
credibility with regard to price stability,
it also made its analysis and objectives
more transparent. The greater trans-
parency may have helped the Federal
Reserve to establish its credibility. In a
similar vein, going public with steps that
make coverage of the uninsured less
likely could establish credibility in
reducing TBTF coverage.”   
Limiting  Creditor Losses
The most direct way to limit the chance
of a bailout is to reduce the expected loss
to  a creditor. This in turn limits the
probability of systemic risk. To accom-
Market Discipline
BOOKR EVIEW
38 Region Focus • Fall 2004
TOO BIG TO FAIL:
THE HAZARDS OF 
BANK BAILOUTS
BY GARY H. STERN AND 
RON J. FELDMAN
WASHINGTON, D.C.: 
BROOKINGS INSTITUTION
PRESS, 2004, 230 PAGES
REVIEWED BY
H. S. MALEKplish this, policymakers must be willing
to close weak but solvent banks, Stern
and Feldman argue. This is not a new
concept. A provision of the Federal
Deposit Insurance Corporation Im-
provement Act of 1991 (FDICIA) allows
policymakers to take “prompt corrective
action” (PCA). Stern and Feldman find
this reform “attractive on a conceptual
basis” but argue that there are flaws in
the way PCAis triggered. 
They suggest that PCAtriggers must
meet four conditions. They must be (1)
largely outside the manipulation of the
bank; (2) reflective of the current risk
profile of the institution; (3) feasible to
calculate routinely and to observe; and
(4) set to close banks likely to fail while
allowing those likely to survive to stay
open. Also, “although it may appear
obvious, to be effective, the early closure
regime must take real steps to
remove the discretion of supervisors,”
the authors write. The current PCA
triggers do not meet those conditions
and thus do too little to limit losses by
shutting down insolvent banks, Stern
and Feldman argue. 
In  addition to instituting more
robust PCAtriggers, Stern and Feldman
would like to see a coinsurance system
instituted for deposits at large banks
that exceed the current FDIC insurance
limit of $100,000. The idea is fairly sim-
ple. “Under a coinsurance scheme, the
insured has to bear some of the loss
rather than have the insurer pick up 100
percent of it,” the authors argue. “For
example, the government could give
itself the right to provide coverage to
the uninsured under extraordinary cir-
cumstances up to a capped amount (say,
75 percent of their funds).”
Stern and Feldman consider some
possible objections to coinsurance, but
one topic they don’t address is the
potential problem caused by discount
window lending by the Federal Reserve,
an issue raised by former Richmond Fed
President Al Broaddus at the Chicago
Fed’s 2000 Annual Conference on 
Bank Structure and Competition. Co-
insurance and other attempts at reintro-
ducing market discipline can be under-
mined if the Fed makes last-minute
loans to failing banks. In effect, the bank
passes on the loss to the Fed as unin-
sured creditors flee.
Also, coinsurance is not costless to
provide, since it involves more insurance
for large banks than they currently
receive. One could envision a number of
ways of funding such a system — for
instance, charging large banks an addi-
tional deposit insurance premium — but
the authors have little to say on the
issue. Certainly, should these ideas move
toward becoming policy, the allocation
of the costs of giving explicit special
treatment to large banks would need to
be considered.
Establishing Credibility
Throughout the book Stern and
Feldman make it clear that they regard
many of the FDICIA reforms as posi-
tive — though insufficient — steps
toward limiting the problems associated
with TBTF policies. Although FDICIA
substantially increased the likelihood
that uninsured depositors would suffer
losses when their bank fails, it also pro-
vided for a “systemic risk” exception.
This exception threatens the govern-
ment’s ability to credibly commit to
closing troubled banks. Ending that
exception and taking a harder line could
help establish much-needed credibility.
But taking a hard line requires putting
your money where your mouth is  — or
in this case, not putting up any money
when a bank goes down. 
Getting creditors to believe that reg-
ulators will allow unsound banks to fail
will not happen overnight. Still, policy-
makers must find a way to “establish
credibility even when they face a history
of actions that undermine the goal.”
(Again, Stern and Feldman point to the
experience of Federal Reserve monetary
policy during the 1980s and 1990s as an
example of an institution earning credi-
bility despite initial skepticism by 
market participants. During that time,
the Fed established its commitment to
achieving price stability following a 
relatively long period of high and 
variable inflation during the 1970s.)
Putting the uninsured on notice by
establishing an easily monitored com-
mitment and then sticking to it would
help do the trick. 
The optimal form of this commit-
ment is not obvious to Stern and
Feldman, though they offer some ideas.
For instance, they suggest appointing
“conservative” bank regulators — “that
is, policymakers who have demonstrated
a predilection for giving serious consid-
eration to the costs of TBTF bailouts
and an ability to reject bailouts where
appropriate.” This is similar to the
appointment of “inflation hawks”
within the Federal Reserve System —
people who took the issue of price 
stability seriously and were willing to
take necessary, if unpopular, actions to
achieve that goal. In short, “personali-
ties matter in establishing credibility,”
write Stern and Feldman.
The payoff from establishing credi-
bility could be large. A “virtuous circle”
might arise in which banks would take
on fewer risks, presenting policymakers
with fewer opportunities to bail them
out. Outside of random shocks, the sys-
tem converges to a situation where
bailouts are no longer expected.
Stern and Feldman have written a
book that is informed by the best basic
research available but which should also
be easily digestible by policymakers and
non-economists more generally. Indeed,
people particularly rushed for time
could profit from reading Chapters 1
and 14, which summarize the book’s
major points. But hopefully many will
take the time to read the entire book —
and to take seriously the proposals con-
tained within. The subject may seem dry,
but it is important. The problems asso-
ciated with too big to fail policies are
simply too large to ignore.  RF
Fall 2004 • Region Focus 39

Book review : Market discipline

http://www.richmondfed.org/publications/research/region_focus/2004/fall/pdf/book_review.pdf

Book review : Market discipline

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Research Papers in Economics