The Story We've Told Ourselves About "Too Big to Fail" is False

There is a story we've told ourselves about what caused the Great Recession of 2008. Here's how it goes:

"Too big to fail" banks engaged in criminal and unethical activities that led to their near collapse, so government (i.e., taxpayers) had to bail them out in order to stop another Great Depression.

With that as the story, a lot of "populist" Democrats suggest that the solution is to break up the "too big to fail" banks in order to prevent us from ever having to bail them out again. Of course that story is combined with the fact of growing income inequality and so many assume that taking the big banks down a peg or two will mitigate the gap.

Finally, blaming the Great Recession on the big banks provides us with a villain to blame for all the pain and suffering of millions who lost jobs, homes, retirement savings, etc.

Given my distrust of conventional wisdom, I've always thought that it is important to do a reality check on this kind of narrative in order to determine if it has any bearing on the truth or if it is simply a liberal version of what Stephen Colbert called "truthiness." Thanks to some great analysis by Michael Grunwald, it's clear that this story we've told ourselves is mostly the latter.

Breaking up the banks is one of those ideas that sound great in theory but less so in reality, a no-brainer until you run it through your brain. It’s not that size doesn’t matter at all, but the debate over size has been absurdly one-sided, ignoring the benefits of bigness, the potential costs of breakups, and what’s already been done to address the too-big-to-fail problem.

Here are some facts to run through your brain:

It wasn't the collapse (or near-collapse) of "too big to fail" that triggered the Great Recession.

Bear Stearns wasn’t even one of the fifteen largest U.S. financial institutions in March 2008, when the Fed had to engineer a massive rescue to prevent it from collapsing and dragging down the global economy with it. Lehman Brothers wasn’t even in America’s top ten when its failure did trigger a global meltdown that September.

"Too big to fail" banks got bigger because they were able to absorb the smaller firms that were failing.

If JP Morgan hadn’t been big and strong enough to absorb the hemorrhaging balance sheets of Bear Stearns and Washington Mutual, we might well have endured a depression. Ditto if Wells Fargo hadn’t been big and strong enough to let Wachovia collapse into its arms. The world is also lucky Bank of America was big and (arguably) dumb enough to salvage Countrywide and Merrill Lynch from the jaws of death.

"Too big to fail" banks were not the only ones engaged in risky behavior and also not the only ones who got bailed out by the government.

And while mega-rescues for mega-banks dominated the headlines, over 900 community banks and regional banks received bailouts through the Troubled Asset Relief Program as well. The government also guaranteed unsecured bank debt, money market funds, and deposits of up to $250,000, which amounted to an even more generous bailout of Main Street banks.

Glass-Steagall wouldn't have helped.

Bear, Lehman, Merrill, Fannie Mae, Freddie Mac, AIG and the other firms at the heart of the crisis were totally unaffected by Glass-Steagall.

What led to the 2008 collapse was not size - but risky bets.

...the main cause of hellacious crises is not overlarge banks. It’s overleveraged banks that make risky bets with borrowed money. Before the panic of 2008, the financial system had a risk problem, not a size problem.

Beware of unintended consequences.

Breaking up the big banks would inject tremendous turmoil into a confidence-based industry where turmoil can have far-reaching unintended consequences.

Grunwald points out that overall, Dodd-Frank is working by raising the capital requirements for big banks in order to protect against the risks. And then he goes on to talk about ways that the current regulations could be strengthened. But ultimately, vigilance is what will be required.

Risk has a way of migrating to the path of least resistance...What’s safe to predict is that risk won’t go away. The goal should be to monitor and manage it, not to eradicate it. Financial reformers often make grand pronouncements about how this or that reform will eliminate the risk of meltdowns and bailouts, but those risks will remain as long as human beings are susceptible to manias like the one that inflated the credit bubble before the crisis and panics like the one that nearly shredded the system during the crisis—in other words, as long as human beings are human.