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[Time] 12:18
History: Continental Illinois's creditors and bondholders avoided direct losses, though can assume the value of the bonds went down when the company got into trouble; once the bailout announced, bonds returned to face value. Equity holders were close to wiped out, or at least not coddled by the government. 1984, one event. Testimony by office of Comptroller of the Currency makes imprudent remark--not just this one company--we'd bail out all eleven. What happens going forward? There was another banking crisis in the late 1980s, early 1990s; many savings and loans institutions did fail and a lot of people lost money. Also episodes of forbearance when some large financial institutions had you marked their balance sheet to market would have been seen to be insolvent. Wasn't done; given time to recover, which they did. Creditors surely understood what was going on; served to reinforce the notion that if you were a creditor of a systemically important financial institution you were likely to be protected directly or indirectly. Next high-profile episode was Long Term Capital Management (LTCM)--different kind of fish, but creditors drew the same conclusion. During the period between 1984 and 1998 (LTCM crisis) many banks went broke. The FDIC covered almost every dollar of depositors' money even when it exceeded the limits the FDIC had promised to guarantee. Changed in 1991 with FDICIA legislation. Government had to engage in least-cost resolution of banks that became insolvent--idea was to impose losses on creditors. Following FDICIA, putting LTCM aside, the FDIC did pursue that policy. Also in FDICIA an out that said to the regulators that you could avoid least-cost resolution if you thought there could be significant systemic adverse consequences from pursuing it. A lot of people thought FDICIA dealt with the too-big-to-fail problem. Because of the loopholes, it didn't deal with it, and what happened in the Continental Illinois case. Have to have agreement among the FDIC, the Board of Governors of the Federal Reserve, the President, and the Secretary of the Treasury in order to exercise the loophole that you are not going to pursue least-cost resolution. But those were the people involved in the decision to bail out the creditors of Continental Illinois. So, FDICIA was just formalizing what was past practice. But in the interim there were some crises paid by creditors in that period. Don't mention the Savings and Loan crisis, Mexican crisis, or other international crises before 1998. Any role in perception of creditors? No significant separate effects. In the wake of FDICIA some creditors did lose money--but all were creditors of relatively small financial institutions. FDICIA never tested; when tested, found wanting. Alan Meltzer, recent podcast: why wasn't FDICIA used in the current crisis? Told Hank Paulson to use it; Paulson said he asked the banks and they were against it. Of course they were against it--it removes their management! People shouldn't have kidded themselves about the prospective effectiveness of FDICIA. Have to prepare for a crisis in advance. Preparation is not easy, but essential.
Gary Stern on Too Big to Fail | EconTalk | Library of Economics and Liberty
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