Major financial institutions are too large and interconnected to be allowed to fail; the government will always intervene to protect the broader economy.
The government allowed Lehman Brothers - then the fourth-largest US investment bank - to fail on September 15, 2008. The failure triggered a global credit freeze. The claim that other institutions were 'too big to fail' was confirmed when the government then did intervene for AIG, Citigroup, and others - but the inconsistency revealed there was no coherent policy.
What changed?
The phrase "too big to fail" entered American economic discourse as a description of a problem, not a policy. The problem was that some financial institutions had grown so large and so interconnected, through counterparty relationships, through assets held by money market funds, through their role in the payments system, that allowing them to fail would cause damage to the broader economy that dwarfed any benefit from market discipline. The government, in this analysis, would always have to intervene.
Economics classes taught the concept in the 2000s as a feature of modern finance worth understanding. It was also understood as an implicit guarantee, if Citigroup or JPMorgan Chase or Bear Stearns was in danger of failing, the Federal Reserve or Treasury would arrange a rescue. The guarantee was never written down, never voted on, but it was understood by markets. This implicit guarantee lowered the cost of borrowing for large institutions, encouraging them to grow larger, take more risks, and accumulate the kind of complex leverage that made the guarantee more necessary.
On September 15, 2008, the Treasury Department and Federal Reserve decided not to rescue Lehman Brothers. Lehman, then the fourth-largest investment bank in the United States with $639 billion in assets, filed for bankruptcy, the largest in American history. The decision shocked markets that had assumed the implicit guarantee held. Within hours, the Reserve Primary Fund, a money market fund holding Lehman commercial paper, "broke the buck", its share price fell below one dollar for the first time in its history. The commercial paper market, through which companies fund daily operations, froze. Global credit markets seized.
Within days, the government reversed course. AIG received an $85 billion emergency loan. Fannie Mae and Freddie Mac had already been placed in conservatorship the previous week. In October, Congress passed the $700 billion Troubled Asset Relief Program. The institutions that were actually too big to fail received bailouts; Lehman, which regulators judged could fail without systemic consequences, could not. The judgment was wrong in both directions.
What TBTF as a concept failed to convey to students was the moral hazard it created: institutions that believed they would be rescued had less reason to manage risk prudently. The guarantee that was supposed to protect the system from catastrophic failure helped produce the reckless behavior that made catastrophic failure possible.
