A primer on 'too big to fail'
David Min offers perhaps the clearest explanation of the "too big to fail" problem that you'll find anywhere:
“Too big to fail” is best understood as a bank panic problem, and has arisen as the result of two developments in the global financial markets over the past several decades. The first development was the tremendous growth of a “shadow banking system” operating outside of the rules that have governed depository banking since the Great Depression. This shadow banking system essentially performed the same functions as banking — attracting short-term investments and using them to finance long-term loans — but did so through the use of entities that were not depository banks, and the use of financing instruments (such as mortgage-backed securities, commercial paper, or short-term repurchase agreements) that were not deposits. Because of this nonbank, nondepository structure, the shadow banking system, which grew to an estimated $10 trillion in size, fell outside the rules and protections of the regulated banking system.
The second development was the concentration of risk within the shadow banking system, such that a small number of financial firms were and are responsible for the vast majority of its liabilities. Before the 2008 crash, the five major U.S. investment banks had a combined balance sheet size of approximately $4 trillion, and this may have understated the true level of liabilities they were holding. Witness the recent revelations about failed Wall Street investment bank Lehman Brothers, which raises questions about the extent to which shadow banks offloaded balance sheet risk through the use of dodgy transactions.
I'm a bit concerned that a lot of the public energy on financial regulation is attaching itself to the Consumer Financial Protection Agency because that's both more comprehensible and more politically useful for Democrats. But how you deal with the TBTF problem is much more important.
March 24, 2010; 3:16 PM ET
Categories: Financial Regulation
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