The phrase ‘Too Big to Fail’ has been used alot since 2008, in reference to various financial firms – and the notion that because of the size of said conglomerates, the failure of any one firm would devastate the economy…

The common narrative in such use, is that we need to break up our banks into smaller ones, and this will somehow prevent another 2008 crisis.

There are, of course, several problems with this:

Problem #1: Smaller banks are MORE likely to fail than large ones.

If you look at the FDIC’s list of distressed banks – eg, banks they siezed and sold off because in their estimates the bank would have failed otherwise… The overwhelming majority are small local and regional banks.

There are some notable exceptions: Washington Mutual, and the one true bank-failure (where the bank was closed without sale, and the FDIC paid depositors) of the 08 crisis – IndyMac…

But the overwhelming majority of failed institutions were the small-fry supposedly ‘safer’ according to the TBTF narrative.

Problem #2: Without big banks, the 08 crisis would have been worse.

The large institutions, particularly Chase, Bank of America, and Wells Fargo – used their size and available reserves to soften the blow of the 08 crisis, by taking advantage of the crash-induced bargain prices to buy out their failed competition. While this was obviously done to benefit the buying bank’s business, it had a secondary effect of containing the crisis and reducing public-panic (by keeping ‘failed’ banks open under new management, there was less incentive for bank-runs on otherwise-healthy banks)….

A plethora of artificially smaller banks, kept that way by government regulation, would NOT have been able to manage this feat – both because the government regulators wouldn’t have allowed it under an ‘anti-TBTF’ scheme, and because the small banks wouldn’t have the cash on-hand to do it.

Problem #3: It’s not the banks themselves that are TBTF – it’s the Banking & Financial Sector

The narrative of an individual institution being ‘too big to fail’ completely misses the point.

The issue isn’t that any one BANK is too big to be allowed to fail – it’s that the BANKING AND FINANCE SECTOR is too big (too important) to be allowed to fail.

Why?

Because the banking sector – not the Treasury or even the Federal Reserve – is what ‘creates’ or ‘prints’ 90% of our money.

Modern monetary systems rely on the making of loans in order to create money – every time money is deposited at a bank, 90% of that money becomes available to be loaned out. Most lent money finds it’s way back into a bank again, where 90% of it can be re-lent, and so on.

Of the ~14TN US Dollars in our money supply, there is approximately 1TN of physical paper and coin (M0). The rest is created by the banking system – a process known as the Fractional Reserve Multiplier Effect.

The result is a system that is far more stable and growth-friendly than the bad-old-days of money being pegged to a commodity (gold or silver being the most common) by arbitrary government decree…

This is also why the Federal Reserve can alter the money-supply by raising or lowering the base-line interest rate – a higher FED rate means a higher price for money economy-wide, which means less lending, a smaller multiplier, and thus less actual money in existence.

However, as a side-effect, this system makes the banking & finance sector an essential part of the economy – to the point that if there were no banks operating, there would be no US economy & the US Dollar would cease to exist as a viable currency.

This makes the safety & stability of the banking sector a matter of national security – since a massive 1929-style loss of consumer-confidence in the banks, and the corresponding runs that would occur if that were allowed to happen – would literally collapse the US Dollar and our economy through deflation. Also, if the markets were to become polluted with instruments of questionable value (questionable being worse than known-low, because at least known-low value has a known value) to the point where no bank is willing to lend a result, the same thing happens.

Think of the economy like an airplane ‘flying’ through a stream of money instead of air… If you increase velocity, you go higher… If you decrease velocity, you go lower… If you STOP velocity (or let it fall too low), you stall, crash & die (Currency Failure via Deflation).

THAT is why the situation in 08 was so bad: a polluted market, and panicky consumers – and having lots of little banks would NOT have changed it one bit – in fact, it likely would have made things worse.

So, if that’s the case, what WAS the problem in 2008, and how do we prevent it in the future

First, it’s important to recognize one thing: When you get to where we were in Sept of 08, you can’t ‘Not Do’ TARP (and BTW, TARP was the most free-market ‘fix’ possible: Buying non-voting shares of stock & letting the banks fix themselves. It also has ended up being a no-net-cost to the taxpayer situation) – that results in the above monetary catastrophe. So bashing politicians for voting for TARP is WRONG – there was no other option at that point. What the politicians deserve to be bashed for, is creating the environment that lead to the crisis in the first place, by way of forcing pollution the securities market with unknown-quantity instruments based on anyone-qualifies home loans.

The problem, quite simply, was a polluted securities and credit market. Why do I say ‘polluted’? Because it’s the best analogy… We had a mixture of ‘clean’ investments with investments of uncertain quality (MBSes and thus the derivatives attached to them). What makes ‘uncertain quality’ worse than ‘low quality’ is that there’s no way to accurately value ‘uncertain quality’ – with known low quality investments (eg junk bonds), you at least know what you’re getting into… However throw a few ‘unknowns’ into an otherwise ‘clean’ market, and the whole market gets presumed to be low-quality because it’s the only way to limit losses.

As for how these ‘unknown quality’ investments got into the market, Government owns that one – by forcing relaxed lending standards accross the board in an effort to ensure home ownership, the government ‘owns’ responsibility for everything that happened downstream – from unknown quality securities, to the complex derivatives tied to them… If the government hadn’t knocked over the first domino, we wouldn’t have the problems we did in the markets, and bingo – no crisis.  No crisis, no paniced consumers, no threat of runs… Also, no panicked banks and no threat of economy-strangling credit tightening…

So, what do we do? To start, what we do NOT do, is change our banking system. There are some radical elements out there that want to essentially ban banking (by eliminating fractional-reserve lending) or move back to a pegged currency. They are all wrong, and in every case the economic and societal costs of that action – in terms of lost oppertunity & innovation, restricted mobility & limited economic growth – are far greater than the downsides of the current system. What we have now has it’s faults, but it has LESS FAULTS than everything else out there.

What we do, is keep the government out of the lending-standards business.

If the government does not intervene, banks will make loans only to credit-worthy borrowers. There will be some defaults, but not the system-wide, economy-threatening level that occurred recently in the housing market.

Some lenders/banks will choose to lend to riskier borrowers (and charge higher rates for it), but this will not be widespread and system-wide as it was when government mandated such behavior (while encouraging NOT charging more for it)… And if one of these fails, they will be bought out by one of their less-risky-lending competitors…. The market handles these sorts of things quite well, as the motivation to earn a profit ensures that lending-standards will be set based on an equilibrium between risk and return generated.

The problem isn’t the size of the banks (that actually HELPED)… It’s the size of our government, and what happens when economic incompetents meddle in affairs best left to professional economists and financiers (this is, btw, also the best argument against Gold Buggery & a Ron-Paul style congressionally-controlled money supply)….

Keep the government out of the financial industry (This includes REPEALING any sort of Glass-Stegall-redux style artificial separation), and let things run their course… Oh, and get rid of Fannie & Freddie – two of the most significant instruments by which the Feds manipulate the housing industry….