The Flawed “Logic” Of Letting Banks Implode

Some of the usual suspects were advocating bank failure earlier this week on Bloomberg TV as a policy roadmap for success during economic and financial crises. It’s a convenient recommendation because the idea’s inherent contrarian drama offers a veneer of logic and provides an entertaining talking point for television. Saving bankrupt entities from the laws of free-market gravity, after all, is grounded in economic logic, common sense and a pro-growth agenda. All true… except when it comes to banks. This isn’t open for debate. Banks are different and must be treated differently when the grim reaper is knocking. Hundreds of years of empirical evidence speak loud and clear on this point. Learning from history isn’t on everyone’s agenda, however. But no matter how many times you insist that down is up, the historical record remains unchanged.

Perhaps the most compelling evidence that bank failure and laissez faire is an unusually hazardous concoction can be found in the succinct but powerful analysis of Yale Professor Gary Gorton’s book Misunderstanding Financial Crises: Why We Don’t See Them Coming:

Banks and bank debt were at the root of every one of the 124 systemic crises around the world from 1970 to 2007 (some also involved currency crises in which the value of the domestic currency decline precipitously). Indeed, there cannot be systemic crises without bank debt.

Letting banks fail has a long and tortured history. Allowing these institutions to implode and allowing the market to sort out the aftermath isn’t some idea that’s never been tested. Au contraire! Economic history is littered with examples of bank failure and the disastrous results that usually followed.

One of the more vivid examples struck the US in the early years of the 20th century. The Panic of 1907 was at its core a banking crisis triggered by institutional failure. Such events had been a recurring blight on the US landscape in the preceding decades, although the 1907 version was unusually toxic. At the time, America had no central bank but all the usual troubles still applied, which led to the de facto creation of a lender of last resort by way of J.P. Morgan, who was dragged into the affair in order to forge a bailout package. The message: letting free-market forces reign supreme in banking is perfectly fine… until it hits you over the head.

It’s no accident that the 1907 crisis was a key event that led to the creation of the Federal Reserve. A radical idea? Not really. Central banking on the fly had been standard procedure all along, but after a series of crises the US decided that it was time to formalize the process and stop asking aging bankers to perform the dirty work that was a regular feature on the economic landscape.

Even after the creation of the Fed the country wasn’t quite done with standing idly by as banks went bye-bye during financial crises. The early 1930s witnessed an unprecedented wave of bank implosions, with the usual results: economic calamity. As Liaquat Ahamed documents in his book Lords of Finance:

The Great Depression was not some act of God or the result of some deep-rooted-contradictions of capitalism but the direct result of a series of misjudgments by economic policy makers, some made back in the 1920s, others after the first crises set in–by any measure the most dramatic sequence of collective blunders ever made by financial officials.

Among the more egregious blunders: letting banks fail.

History is clear on this point, but the lesson needs to be re-learned from time to time. Indeed, during the 2008 crisis there was a critical event that arguably turned what might have been a garden-variety economic recession into something approximating a full-blown meltdown with global proportions with repercussions that are still with us: the failure of Lehman Brothers.

Professor John Cochrane outlined the key issue with Lehman and why it marked the point of no return:

We are left with only one plausible explanation for why Lehman’s failure could have had such wide-ranging effect: After the Bear Stearns bailout earlier in the year, markets came to the conclusion that investment banks and bank holding companies were “too big to fail” and would be bailed out. But when the government did not bail out Lehman, and in fact said it lacked the legal authority to do so, everyone reassessed that expectation. “Maybe the government will not, or cannot, bail out Citigroup?” Suddenly, it made perfect sense to run like mad.

The nature of banking makes it different than every other industry. When a bank collapses, there are financial repercussions that spiral out into the wider economy and often to other banks, which in turn reverberates deeper and wider into economic activity. It’s no great disaster if a widget-maker fails. But when a bank crumbles, it spreads panic because of the nature of the business: your money.

All of which leads to the recognition that an ounce of prevention is worth a ton of cure. Informed regulation is necessary to keep banks from taking on too much risk. Alas, the record on this front is mixed at best. Indeed, quite a lot of what went wrong in 2008 is directly related to flawed banking regulation that allowed institutions to flirt with disaster.

None of this changes the fact that letting banks fail is still a recipe for disaster. The time to act is before banks go off the deep end. But finding the optimal mix of regulations isn’t obvious. By design, banks are in the business of taking on risk. The dual and conflicting aspect of taking in deposits and lending/investing a portion of the assets is problematic when a majority of depositors want their money… NOW! Sure, it’s easy to create regulation that would virtually assure bank safety. The problem is that engineering a super-safe banking environment would greatly reduce if not eliminate the rationale for banking in the first place: transferring risk to a third party via lending and other financial-related activities. In short, the potential for bank failure can’t be engineered away entirely, which means that there’s always another panic out there somewhere. The main reason is that no one’s yet figured out a way to dispense the business cycle to the dustbin of history.

Improvements in regulation can help and on that front there’s plenty of room for progress. But rest assured that bank failures will continue to pop up. It’s the nature of the beast. Modern economies can’t work without banks (or some form of financial intermediary). But there’s a cost that arises from tolerating these necessary but sometimes-fragile institutions. Arguing that there’s no cost, i.e., banks can fail without serious consequences for the economy, runs contrary to the lessons in the historical record.

Letting banks fail, in other words, is short-sighted and more than slightly dangerous. But, hey, it does provide the basis for an entertaining discussion on TV!

6 thoughts on “The Flawed “Logic” Of Letting Banks Implode

  1. Jack

    I am not sure you have really proven your proposition, but it may be an issue of terminology. For example, are bankrupt, fail, and implode all the same thing? Or even more fundamental: what is a bank? My memory may be faulty, but I don’t recall Lehman having a banking charter. If it did, I suspect it was via some arm’s length sub.

    Actually, this country allows ‘banks’ fail all the time. According to the FDIC website the Hometown National Bank of Longview, WA did so just recently.

    And I am not sure your citations are really all as presented. Been awhile since I read it, but if I took a lesson from the Lords of Finance it was less an issue of letting banks fail as it was horrendously conducted monetary policy. An example might be returning to a gold standard at a pre-war parity by certain countries and how the US then deployed its monetary policy to accommodate that.

    While I haven’t read Gorton, my sense from Reinhart and Rogoff and from McKinsey would be that many of the financial crises were not so much banks per se, but the intertwining of banks, debt, and governments. Indeed, a case can be made that much of what has transpired in Europe in recent years involved politicians trying to hide the nexus of overly indebted sovereigns, banks, and monetary mechanisms (Target 2, anyone).

    Having not watched the Bberg piece inducing your reaction, I guess you may have effectively rebutted it. That said, I’ll continue to think banks and other financial entities can be allowed to fail.

  2. James Picerno Post author

    Jack,
    You are correct in that banks do continue to fail. The key point is that the government makes the depositors whole. If it were otherwise, chaos would reign and bank runs and all that follows would be routine–a critical oversight in the Great Depression.
    As for the Lords of Finance, we live on different planets if you see the book’s narrative as supporting the case for a gold standard. Instead, I see a story that offers a popular history of the results documented in Barry Eichengreen’s “Golden Fetters: The Gold Standard and the Great Depression, 1919-1939,” which effectively demonstrates that the empirical record on the gold standard was economically disastrous. As one example, Eichengreen’s research shows quite clearly that taking the US off the gold standard in ’33 was crucial for unleashing a recovery. Lots of supporting research comes to the same conclusion–Ben Bernanke and Scott Sumner’s papers, for instance. In addition, adhering to a gold standard was part and parcel of the rationale for letting banks fail in the thirties, which is to say allowing depositors to bear the brunt of the losses. The Lords of Finance is quite explicit in showing how the bank runs exacerbated and extended the recession’s depth and breadth by leaps and bounds.
    You are correct in noting that financial crises aren’t always and everywhere due to wobbly banks per se. Financial crises are complicated. But there’s usually a banking aspect.
    As for Lehman, the defacto banking aspect of the institution–lots of “depositors”, ie, clients and debts/assets linked to other financial institutions/banks globally makes this a “bank” in practice with all the usual risks bound up re: failure.
    The bottom line: the historical record is quite clear: letting banks fail in the sense of allowing depositors to suffer complete losses is a dangerous idea.
    –JP

  3. Jack

    No, I am not suggesting the Lords of Finance supports the gold standard. I am suggesting it supports the idea that governments’ attempts to return to said standard at something approximating pre-war parity and how the CBs handled the situation was a causal factor in what subsequently transpired. Beyond that, I didn’t intend to get into a debate about what Eichengreen and others have ‘proven’ although I admit at times I think there is a bit of a straw man element to their proofs.

    I guess we come back to how you phrased your piece. Financial intermediaries can and should fail (implode). In your last paragraph you seem to define what constitutes a bank and, perhaps, a ‘depositor’ rather broadly. If you are going to protect all “clients and debt/assets linked…”, which a sentence or two later you seem to conflate with depositors, you may as well nationalize the system because the moral hazard is huge. This is what needs to stop.

  4. James Picerno Post author

    Jack,
    Ok, point taken. If we were writing actual policy and implementing it, the details could get messy and so broad notions about not letting banks fail would require discussion about what exactly that means. That said, my post is far less ambitious and focused on the general proposition advanced in some circles that banks shouldn’t be “saved” when they “fail.” Of course, there’s room for debate, depending on how one defines terms. In any case, I start from the baseline view that the historical record on bank “failure” isn’t encouraging and so steps should be taken to minimize the blowback. I’m open to the possibility that these general lessons can be modified, but that’s beyond my pay scale.
    –JP

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