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[Time] 0:36
Intro. [Recording date: September 25, 2009.] Book life-changing; written 2004; fundamental questions of the financial crisis. Why would a firm like Bear Stearns or Lehman Brothers take so much risk? Why would they be so leveraged, put themselves in a position where a bad quarter would kill their firm? Yes, there have been bailouts in the past, but they were partial; punished equity-holders. Should induce some prudence. But punishing equity holders while bailing out bond holders and creditors has some subtle incentives that are not so obvious. Start with modern history of bank bailouts in the last 25 years. What has happened and what form? Continental Illinois, forefather in modern times. At the time, highly regarded commercial bank, highly regarded. Failed because of energy-related exposures throughout the country. Creditors, large and small, and even beyond the creditors were protected by the Federal government and didn't suffer any losses. Reason for that protection: policy-makers' concerns about contagion or spillover effects, meaning the concern was that problems at Continental would affect other financial institutions, other markets, and the performance of the economy in terms of output and employment. Decision made to try to limit the damage. They were the 7th or 8th largest bank in the United States at the time, though listeners today have never heard of them. Very large bank, 5000 counterparties, connected with other creditors, borrowers, and lenders. Had borrowed a lot of money from community banks around the country, who had exposure to Continental in excess of their capital. Would have cascaded. Wasn't the only problem, but part of it. Congressional testimony after episode, Comptroller of the Currency indicated there were 11 banks he considered too big to fail. Message received by creditors. Moral hazard: normal prudence for a creditor is that you don't want your borrower to go bankrupt so you can be repaid for your loan. Creditors don't get any upside--collect interest, expect to get principal back; no matter how well the firm does you won't do any better than that. Compare with equity holders. Imposing losses on equity holders doesn't do any good in terms of moral hazard. Seems counter-intuitive. They don't want to lose their equity. Depends on how diversified the equity holder is. If you are a large institutional investor owning equity in lots of different companies around country or globe, don't have a large exposure to any one company. If one goes bankrupt, it doesn't have a large effect on your performance. Contrast to a community bank that is family owned--lots of incentive to be prudent. Can't say the same for equity holders of large institutions where equity is broadly held. Deep insight: bond holders, creditors, and equity holders. Tend to think of the equity holders as group standing on the side reminding firm not to be too risky. High-risk stock adds zest to their portfolios; risk versus return. Don't get above normal returns without above normal risk; diversify portfolios.
Gary Stern on Too Big to Fail | EconTalk | Library of Economics and Liberty
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