The phrase “too big to fail” (TBTF) has been used a lot throughout the credit crunch of the last twelve months or so. Now it seems that American International Group (AIG) was too big to fail as it was bailed out by the US Federal Reserve (the “Fed”), while Lehman Brothers was not and was allowed to collapse in ignominy. For those outside the financial markets, it probably doesn’t make a lot of sense (not that it makes much more sense for those on the inside), so what is going on here?
There is an old saying that if you owe the bank $1,000 that’s your problem, but if you owe the bank $1 million that’s their problem. Something similar is at work at the moment in the financial markets.
In theory, companies in a capitalist economy are free to stand or fall on the results of their own business decisions. If they do fall, investors who chose to buy shares or bonds will lose out, but that risk is supposed to keep everyone focused on making better decisions. Banks have always been a little bit different, for two reasons. First because they take deposits from “mums and dads” (or, as the banks call them, retail depositors) and it is in the interests of the smooth-running of the whole system that this money is put into banks rather than under the mattress. Hard experience over the years of bank runs has led to various forms of depositor protection around the world, such as Government guarantees in the US through the Federal Deposit Insurance Corporation (FDIC). Of course, banks make a decent, albeit shrinking, profit from all these protected deposits.
It has been estimated that the US sub-prime mortgage crisis has resulted in over US$450 billion in write-downs to date and, earlier this year,