The current financial crisis has popped a few popular myths about the financial system. There was a fairy tale, for instance, that Fannie Mae and Freddie Mac were not backed by the U.S. government, and another that depositor discipline - the ability of depositors to penalize (discipline) banks for poor performance by withdrawing deposits-is healthy for the system. It turns out bank runs aren't so desirable. But perhaps the most outlandish myth dispelled is that there was no such thing as too big to fail, that the dispersal of risk across the global financial network meant the failure of any institution could be absorbed.

The reality is quite the opposite of course. Institutions can be too big to fail. Not only that, the failure of even small institutions can have unforeseen and damaging ripple effects in markets. This is why when people in the industry talk about too big to fail what they really mean is "too interconnected to fail." The global financial system, long heralded as resilient thanks to its interconnectivity, has been made brittle by it.

John Douglas, a partner at Paul, Hastings, Janofsky & Walker and general counsel to the Federal Deposit Insurance Corp. during the savings and loan crisis, says: "Clearly, it's a fact of life. There are institutions too interconnected for at least the debt obligations to be repudiated and walked away from." Government intervention in AIG, Fannie, Freddie, Bear Stearns and Wachovia-not to mention all the interventions in overseas markets - proved this reality. The decision to allow Lehman to fail, and the cascading consequences, have further reinforced this too-interconnected-to-fail lesson.

All this raises critical questions. Which institutions are too big too fail, to begin with, and can the U.S. government intervene in financial markets without warping them? As Douglas points out, state-owned banks in the developing world are common and "every one distorts the market in pernicious ways." Since they are seen as safer than private banks, they can price products and services differently and advantageously.

In the U.S., a rash of acquisitions and direct equity infusions by the government into U.S. financial institutions are clarifying which firms are too big to fail: Bank of America, JPMorgan Chase, Citi, Wells Fargo all fall into this tier, and probably Goldman Sachs and Morgan Stanley as well. For a rough barometer consider that Wachovia, with $812 billion is assets, was too big to fail, while Washington Mutual, with $310 billion, was not.

The emergence of this tier may put extreme pressure on the mid-tier banks in the long term. Institutions such as Fifth Third, SunTrust, PNC, Nat City, will be squeezed, observers say, and some may choose to band together through mergers in a race to attain too-big-too-fail status of their own. Community banks, meanwhile, may do just fine. Their local, personalized service could stand in stark contrast to the national behemoths.

As for whether the government can have a hand in the market and not distort it, the consensus is no. But certain steps could help. Indeed, James Barth, a senior fellow at the Milken Institute and a finance professor at Auburn University, says that such steps are vital to ensure large institutions do not-emboldened by their status-take undo risks that put taxpayer dollars on the line. The government should establish and announce to the markets a measurement for too big to fail, and put in place a clear plan to handle the breakup of these institutions should they run into trouble, Barth says.

The critical lesson, however, is that a tier of too-big-to-fail institutions has emerged, and will continue to exist even after the current financial crisis passes. The government would serve the financial system well by owning up to this fact, and not creating a new myth that this is not so.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.