Why Too Big to Fail is a Myth

Abstract

Many economists have argued that it is necessary to reorganize big banks that require sustained subsidies or are close to insolvency. By wiping out the shareholders and giving haircuts to bondholders, the resulting reorganized banks will be financially sound and capable of leading the country out of recession. But there are fears that failure of large financial institutions will cause systemic financial market failure and they are therefore “too big to fail.” In this note, the author argues that the US experience, shows that “too big to fail” is a myth. When Washington Mutual failed, it was 6-7 times larger than the previous largest US bank to fail; it was placed into FDIC receivership and reopened literally the next day as J.P Morgan Chase, with account holders having full access to their deposits and bank services. More worrisome to many is the failure of a central player in the counterparty operations. But when Lehman Brothers went bankrupt, it was the third largest user worldwide of credit default swaps for mortgage backed securities. It had its massive credit default swap holdings unwound within four weeks by the Depository Trust and Clearing Corporation (DTCC) and its subsidiaries, with all parties receiving payment on the terms of their original contracts. Moreover, through the DTCC and new developing exchanges, there are financial market institutional mechanisms in place designed to assure that the smooth resolution of credit default swaps, as occurred in the Lehman case, will hold in general.