Failure at the Financial Stability Board

WASHINGTON, DC – At least since the fall of 2008, leading economies’ officials have agreed – in principle – that something must be done about financial firms that are “too big to fail.” Great efforts, including countless international meetings, working papers, and communiqués have been devoted to this end. Earlier this month, the Basel-based Financial Stability Board (FSB) announced, to some fanfare, the completion of a major stage in this project. But the announcement only served to underscore how little progress has been made. The world’s largest banks remain too big to fail, and this is likely to have dire consequences in the near future.

The problem of too big to fail is not new – the phrase was first used in the United States in the 1980s. It refers to any firm – usually in the financial sector – whose failure would have major negative spillover effects for the rest of the financial system and for the real (non-financial) part of the economy.

Prior to September 2008, there was some doubt as to whether large non-bank financial firms would be regarded as too big to fail. Bear Stearns came close to failing earlier that year, before the Federal Reserve stepped in to facilitate a purchase by JPMorgan Chase. Bear Stearns’ shareholders did not do well and much of its management immediately left the scene, but creditors were fully protected (in fact, ensuring this protection was a central motivation for the Fed’s intervention).

When Lehman Brothers came under severe pressure in September 2008, uncertainty reigned in financial markets (and at the top of Lehman): perhaps the Fed would help out again in some fashion. By all accounts, the US Treasury and the Fed did indeed consider providing assistance, but then held back, worried about overstepping their legal authority and sufficiently confident that permitting Lehman to fail would not have dire consequences for the broader economy.