Were Banks "Too Big to Fail" Before the Fed?

Continental Illinois, Gary Gorton, lender of last resort, Too Big To Fail, Walter Bagehot
"Suspension of the Metropolitan Bank, 1884," engraving from Frank Leslie's Popular Monthly, Vol XVIII No. 5, November 1884. https://books.google.com/books?id=3PFAAQAAMAAJ&pg=PR6&lpg=PR6&dq=suspension+of+the+metropolitan+bank+1884+engraving&source=bl&ots=RgZJebyPCB&sig=AqCItg5F-thhZ0yRcxvEw4Bpqts&hl=en&sa=X&ved=0ahUKEwi13J2q09LLAhXCbz4KHeQABYUQ6AEILTAC#v=onepage&q=suspension%20of%20the%20metropolitan%20bank%201884%20engraving&f=false

Metropolitan4According to Gary Gorton and Ellis W. Tallman, in their  recently released NBER Working Paper, some were.

For several decades prior to the Fed's establishment, Gorton and Tallman note, "private bank clearinghouses provided lending facilities and assisted member banks when they needed help."  The pattern of such assistance, they say, reflected a privately-adopted TBTF policy that "was a reasonable response to the vulnerability of short-term debt to runs that could threaten large banks and thereby the entire banking system."

These clearinghouse bailouts appear, furthermore, to have succeeded in averting more serious crises.  Since, according to Gorton and Tallman's understanding, "[t]he logic of modern bailouts is the same" as that adopted by 19th-century clearinghouses, they conclude that TBTF remains a reasonable policy today, and not, as many suppose, an invitation to excessive bank risk taking.

But there's a flaw in Gorton and Tallman's reasoning, and I'm afraid it's a lulu.  The flaw consists of their failure to understand what "Too Big to Fail" means.  That meaning has been clear from the time  Congressman Stewart McKinney first popularized the notion during a hearing concerning the Continental Illinois bailout.  "Mr. Chairman," McKinney said, "Let us not bandy words.  We have a new kind of bank.  It's called too big to fail.  TBTF, and it's a wonderful bank."

In case it isn't obvious, Congressman McKinney was being sarcastic.  What was "wonderful," in the sense of "amazing," was the fact that Continental would remain a going concern despite it's having been rendered insolvent by bad loans it had made or purchased.  The point is that, if TBTF means anything, it means that certain financial institutions are exceptions to Walter Bagehot's "classical" rule according to which last-resort loans and other kinds of emergency aid should be confined to solvent financial firms.  It is precisely because TBTF can mean putting insolvent firms on government life-support that critics of the policy see it as a source of moral hazard.

All of this appears, somehow, to have escaped Gorton and Tallman's attention.  For otherwise they could not have failed to note the crucial difference  between "the logic of modern bailouts" and that underlying the private pre-Fed bailouts that their paper describes.  For while clearinghouses did occasionally rescue "big" banks, they never rescued insolvent ones.  Instead, as is clear from the evidence that Gorton and Tallman themselves muster, clearinghouses went to great lengths to assure themselves of a bank's solvency before they'd lend it a nickel.  "If a bank possesses good assets and is merely temporarily embarrassed," a 1901 source cited in the paper explains, "it is good policy of the [clearinghouse] association to prevent [its] failure."  That's not too big to fail.  It's too sound to fail.

And while it's true that, according to the same source, clearinghouses were especially concerned to prevent "important" members from failing, because such failures try "the weak points of all the banks," such banks still had to have plenty of  "good assets" to qualify for help.  During the Panic of 1884, for example, the failure of the Metropolitan National Bank might have had disastrous consequences for its many correspondents.  Yet the New York Clearing House agreed to offer it support in the form of clearinghouse loan certificates only after its examiners determined that the Metropolitan "had sufficient assets in good condition" to warrant that support.  In short, "Bigness" (or "interconnectedness") may have been a necessary condition for clearinghouse support.  But it was never a sufficient condition.

In a TBTF regime, in contrast, "bigness," or "interconnectedness," can suffice.  Hence Continental Illinois.  Hence other bailouts of larger, insolvent financial firms since them, including the Fed's rescues of Citigroup and AIG during the recent crisis.  As Tom Humphrey points out,

the Fed ignored the classical advice never to accommodate unsound borrowers when it helped bail out insolvent Citigroup and AIG.  Judging each firm too big and interconnected
to fail, the Fed argued that it “had no choice” but to aid in their rescue since each formed the hub of a vast network of counterparty credit interrelationships vital to the financial markets, such that the failure of either firm would allegedly have brought collapse of the entire financial system.  Fed policymakers overlooked the fact that Bagehot already had treated this argument, and had shown that interconnectedness of debtor-creditor relationships and the associated danger of systemic failure constituted no good reason to bail out insolvent firms.

The difference between the "logic" of the private-market financial firm rescues of the pre-Fed era, in which the rescuers themselves had "skin in the game," and today's taxpayer-supported rescues, is a difference of no small importance.  It is why we worry about TBTF these days, while no one worried about it back then.

I hope I won't be misunderstood as intending to suggest that there's no merit in Gorton and Tallman's research, because that isn't my intention at all.  In fact I consider their inquiry into clearinghouse rescues of the pre-Fed era quite valuable.  The problem isn't the research itself, but the fact that Gorton and Tallman draw the wrong lesson from it.  The lesson isn't that TBTF is a dandy doctrine, and that those looking for the causes of financial-system fragility today should look elsewhere.  It's that private, 19th-century financial actors appeared to have managed last-resort lending more responsibly than their modern, government-appointed counterparts.

  • http://www.rcwhalen.com/ rcwhalen

    The members of the pre-Fed clearinghouses probably would not have seen support provided to troubled banks as a bailout. More often than not, support was refused and the weaker banks were bought by the strong. Once a solvent bank makes a loan to a troubled institution, the creditor is essentially the owner unless and until the loan is repaid. One of the reasons that the Fed was created was dissatisfaction with the clearinghouse system, both as providers of liquidity in the normal course of business and support for troubled banks. TBTF is a political decision, so I am not sure this comparison is meaningful. Agree with George that the private arrangement was better in many ways. Indeed, today when smaller banks get into trouble, the FDIC quietly orchestrates a sale to a larger institution. So nothing has really changed.

  • Dan Thornton

    "Inter disconnected," "systemically important," are fuzzy, ill-defined terms that the Fed has used to recuse large financial institutions. That such bailouts are unnecessary is evidenced by the Lehman experience: Lehman failed on September 15, 2008, the Fed immediately massively increased the monetary base (the total supply of credit). Default risk spreads, which had exploded following Lehman's announcement, had stabilized considerably by February 2009 and the recession, which began on December 2007, ended in June 2009. Bailouts motivated by "fear" based on fuzzy rational reward risky (in some case fraudulent) behavior. The guilty get saved and the innocent pay!

  • http://www.examplesofglobalization.com/ Gary Anderson

    The Fed even went so far as to hide bad bank loans in SIVs, off balance sheet, where I suppose the Fed thought that the commercial banks could somehow hide from their connection to the commercial paper market, which collapsed because of the subprime panic in August of 2007. That was, by the way, way before other crises hit in the middle to late 2008. The Fed should have seen their own FRED chart showing the destruction of the CP market. Guess they were too busy looking at how nice inflation was humming along.

  • a2plusb2

    Among other things, we need a better statement of what 'fail' is. And more importantly, what the consequences of failing need to be.

    (– As an indication of how little we have been talking of it, the furthest I have heard anyone is that the furthest-left believes that the top bank executives should go to jail if their bank fails.)