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The Lessons of 'Too Big to Fail'

May 16, 2014

Thirty years ago, on May 17, 1984, the Federal Deposit Insurance Corporation (FDIC) announced a multi-billion-dollar rescue of the failing Continental Illinois National Bank and Trust Company, following a run by the bank’s depositors. The FDIC also said it would protect creditors who were not normally shielded from a bank’s failure. The decision set a precedent that the global banking system is still trying to come to terms with—the idea of a financial institution that is “too big to fail.”

One of the 10 largest US banks at the time, with about $40 billion in assets, Continental Illinois represented the largest bank failure in American history until the financial crisis of 2007-08, when regulators again stepped in to rescue banks and other major financial companies.

“We thought that much of what happened in the most recent financial crisis was new, but there are a lot of parallels to Continental Illinois,” said Randall S. Kroszner, Norman R. Bobins Professor of Economics and a governor of the Federal Reserve System from 2006 to 2009. “Its problems were related to insufficient liquidity, excessive leverage, and fragile interconnections, both domestic and international—themes that have emerged again in recent years. Examining what happened back then can give us lessons for the future.”

On May 15, Kroszner and other Chicago Booth professors joined key participants in Continental Illinois’s rescue, as well as researchers who have studied the “too big to fail” dilemma, for a day-long conference and a lively debate about the most effective policy responses to systemically important financial firms. The conference was organized by the George J. Stigler Center for the Study of the Economy and the State, with financial support from The Clearing House Association.

In the months leading up to its failure, Continental Illinois recorded a skyrocketing number of bad loans, many linked to the bursting of the energy bubble of the early 1980s. The bank was able to remain solvent until its Japanese and European lenders abruptly stopped providing short-term funding. Regulators feared that if they didn’t intervene dramatically, the problem would spread to other US financial firms—similar to what actually happened in the recent crisis.

“The broader learning from Continental Illinois is that if you’re facing a potential panic, you stop it early, rather than letting it grow as happened in 2007 and 2008,” said Oliver Ireland, a partner at Morrison & Foerster LLP and former vice president and associate general counsel of the Federal Reserve Bank of Chicago.

But that choice remains deeply controversial, as evidenced by the heated discussion among Ireland and other panelists. They debated about exactly what regulators should have done back then, and how their actions may have encouraged moral hazard in subsequent decades among big banks, which many participants believe took on undue risk with the expectation that they would be rescued in a crisis.

There will always be short-term benefits to a bailout, said Philip Strahan, professor and John L. Collins, S.J. Chair in Finance at the Carroll School of Management at Boston College. “Agents working on short-term time horizons are going to place much less weight on long-term moral hazard problems that are going to happen on somebody else’s watch,” he added. The result, he said, is that the expectations of a bailout distort markets, possibly encouraging financial firms to borrow more than they should.

Research by Bryan Kelly, assistant professor of finance at Booth, provides evidence for these market distortions. Kelly examines options on financial stocks, which he says represent the price of insurance against a system-wide crash. In his data which go through 2010, he finds that bailouts effectively subsidize equity holders by making the price of insuring the financial sector less than it would be if investors didn’t assume that regulators would rescue failing firms. “This starts to be some treacherous terrain,” Kelly said. “It looks like a rational expectations spiral.”

Paul Saltzman, president of The Clearing House, countered that the 2010 Dodd-Frank Act has fundamentally changed the playing field for financial companies. “We are embracing the policy of shrinking banks, deleveraging banks, and reducing the global footprint of our banks, all in the name of mitigating too big to fail,” he said.

Strahan and Kelly agreed that Dodd-Frank has reduced the incentives for banks to take excessive risks, but they warned against complacency. “The danger is that the cycle repeats as memories start to fade and markets adapt,” Strahan said.

What can be done to ward off another systemic panic? While some of the panelists argued that another financial crisis is inevitable, some proposed ideas to avert the runs on deposits that terrified investors in 2007-08.

John Dugan, a partner at Covington & Burling LLP and comptroller of the currency from 2005 to 2010, suggested that financial institutions need a large cushion of subordinated claims to absorb losses, protecting the short-term creditors that can spark bank runs by rushing to withdraw their deposits.

John H. Cochrane, AQR Capital Management Distinguished Service Professor of Finance at Booth, argued that banks should fund themselves primarily through equity, he said, and not through the short-term debt that is vulnerable to a run. “If we could cure the runs, we could have financial booms and busts without a financial crisis,” he said.

It’s crucial to figure out now how to respond to the next big bank failure, said Gary Stern, the former president and chief executive of the Federal Reserve Bank of Minneapolis. Stern coauthored the book Too Big to Fail: The Hazards of Bank Bailouts in 2004, several years before the financial crisis. In his keynote speech, he recommended that regulators emphasize that uninsured creditors will not be protected when a bank fails, and that firms have plans for an orderly resolution.

“The key is to change the position of regulators and policymakers, so they come to understand they can wind these institutions down and impose losses at tolerable costs,” Stern said. “If policymakers don’t have that confidence, they will always resort to bailouts in the name of preserving financial stability.”—Amy Merrick

Panel One
The Failure and Rescue of the Continental Illinois 30 years Ago: Difficult Policy Decisions and Economic Consequences

Randall S. Kroszner (moderator), Norman R. Bobins Professor of Economics, Chicago Booth
Michael Bradfield, general counsel of the Volcker Alliance; former general counsel for the US Federal Reserve
Oliver Ireland, partner, Morrison & Foerster LLP; former vice president and associate general counsel of the Federal Reserve Bank of Chicago
Jack Murphy, chief executive officer, Promontory Regulatory Analytics, LLC and managing director, Promontory Financial Group, LLC; former general counsel at FDIC; and a former partner of Cleary Gottlieb Steen & Hamilton LLP
Donald Toumey, partner, Sullivan & Cromwell LLP; former special assistant to the general counsel of the US Department of the Treasury

Panel Two
Regulatory and Market Responses to “Too Big to Fail” and Moral Hazard Following the Failure of Continental Illinois

Sam Peltzman (moderator), Ralph and Dorothy Keller Distinguished Service Professor of Economic Emeritus, Chicago Booth
Deniz Anginer, assistant professor of finance, Pamplin College of Business, Virginia Tech
George Kaufman, John F. Smith Professor of Finance and Economics, Quinlan School of Business, Loyola University Chicago
Bryan Kelly, assistant professor of finance, Chicago Booth
Philip Strahan, professor and John l. Collins, S.J. Chair in Finance, Carroll School of Management, Boston College

Panel Three
The Current State of “Too Big to Fail,” What are the Most Effective Policy Responses

Douglas Diamond (moderator), Merton H. Miller Distinguished Service Professor of Finance, Chicago Booth
John Cochrane, AQR Capital Management Distinguished Service Professor of Finance, Chicago Booth
John Dugan, partner at Covington & Burling LLP; former Comptroller of the Currency (2005-2010)
Roberta Romano, Sterling Professor of Law, and director, Yale Law School Center for the Study of Corporate Law
Paul Saltzman, president, The Clearing House Association; executive vice president and general counsel of The Clearing House Payments Company