WASHINGTON The doctrine of too big to fail is the elephant in the room at the Federal Reserve Board everyone knows it is there, but nobody wants to admit it.
When Fed officials discuss this belief that the government will rescue large financial institutions on the brink of failure to prevent a meltdown of the economy, it is only to debunk the notion.
No institution is too big to fail, Fed Vice Chairman Roger Ferguson assured a group of community bankers at a conference here two weeks ago. It is absolutely not a concept that deserves much merit at this stage.
Mr. Fergusons words echoed official central bank policy, and a speech a week earlier by Fed Chairman Alan Greenspan.
But the issue wont die. Critics have capitalized on the debates over reform of government-sponsored enterprises and the deposit insurance system to renew complaints that explicit and implicit federal guarantees give big companies an unfair advantage over small ones. Some feel that until the issue is resolved, reform will never be fully successful.
And as much as policymakers dismiss the concept, industry analysts and former regulators remain unconvinced.
Everybody knows that there are institutions that are so large and interlinked with others that it is out of the question to let them fail, said Alan S. Blinder, a former Fed vice chairman. But the last thing a regulator would want to do is tell any particular institution that its on the list or tell customers that its on the list, which would of course give it a very unfair competitive advantage.
Mr. Blinder, now a managing partner at the Promontory Financial Group consulting firm here, said that Fed efforts to deny the concept are not quite true but if you are a federal regulator, you want to say it early and often.
Though Fed officials have been considering the issue carefully in recent weeks the Federal Reserve Bank of Chicago hosted a conference last month on the federal safety net some say there may be no good solution.
William Isaac, chairman of Secura Group in Falls Church, Va., and a former chairman of the Federal Deposit Insurance Corp., said that if the Fed were to reverse course and admit that the doctrine really exists, it would only raise more dangerous questions.
If I were a policymaker at the Fed or FDIC and got up and pronounced there is such a thing as too big to fail, people would assume the largest institution is too big to fail, then at least the next three or four, said Mr. Isaac. Doubt would only enter the picture as to how far down the list you went. It would be a serious policy blunder if someone made that announcement.
Most analysts agree that if there were a definite list, it would give those institutions an unfair advantage, and create an outcry among those not on the list. Speaking at the Chicago Fed conference two weeks ago, Mr. Greenspan said that creditors and depositors would cease to worry about a banks policies if it knew they were fully protected.
Uninsured counterparties have little reason to engage in risk analysis, let alone act on such analysis, if they believe that they will always be made whole under a de facto too big to fail policy, Mr. Greenspan said.
That was why, Mr. Greenspan argued, it was important for shareholders, bank managers, depositors, and other uninsured creditors to believe that the government would not save them. More importantly, he emphasized that as large banking organizations continue to make acquisitions and take on new powers granted by the Gramm-Leach-Bliley Act of 1999, it was even more critical that there is no perception of a federal safety net.
As financial consolidation continues, and as banking organizations take advantage of a wider range of activities, the perception that all creditors of large banks, let alone of their affiliates, are protected by the safety net is a recipe for a vast misallocation of resources and increasingly intrusive supervision, he said.
Indeed, central bank officials have repeatedly emphasized that if a large bank were to fail, there would be drastic consequences for stockholders and others involved.
Fed Governor Lawrence H. Meyer, also at the Chicago Fed conference, insisted the popular understanding of the doctrine is off base. Though he acknowledged that there may be some instances where federal regulators would step in to save an institution from failure, Mr. Meyer insisted that equity holders would likely be wiped out, management fired, and uninsured creditors clipped.
In any case, many analysts worry that continued Fed denials will not accomplish its goal. It will take regulators following through on their threat to depositors, or investors losing money after a large failure, before anyone believes the government is willing to just stand by and watch, these analysts say.
If the past is any judge, regulators have a hard time standing by. As recently as 1998, the Fed organized a private sector bailout of Long Term Capital Management, a hedge fund whose failure threatened the stability of the economy.
One of the most famous examples of recent bank runs and too big to fail concerns is the rescue of Continental Illinois in 1984, which was then the eighth-largest banking institution in the country. It was saved by the FDIC, the Fed, and a consortium of banks after rumors of its demise caused a run on the bank.
That near failure was one of the reasons Congress enacted the systemic risk exception in the Federal Deposit Insurance Corp. Improvement Act of 1991, which allows for the Treasury secretary, after consulting with the President, to rescue a bank if they determine its imminent failure could cause significant damage to the economy. If such a determination is made, the bailout is paid for by a special assessment on the banking industry.
Mr. Isaac said the only solution will be a complete repudiation in law of too big to fail. He argued that bailouts should only be available through an act of Congress, and should not be in the hands of regulators. Though as FDIC chairman he helped rescue Continental Illinois, he said that at the time it was too late for regulators to take a hard line, but that the only way for institutions to truly believe they had no federal safety net would be to leave it solely in the hands of Congress.
You cant bet on what Congress is going to do that in itself instills the discipline you need, Mr. Isaac said. And if they did step in, they would exact a pound of flesh from the people who brought us the problem. But I dont think you can change it in the middle of a crisis. What you can do is change it when the system is doing well, like today. Now is the perfect time to change the system, and people can govern themselves accordingly.
At least for now, most analysts think it is unlikely Congress will take action, and it remains to be seen how concern over the issue will continue to affect future banking legislation. Unless Congress intervenes, Mr. Blinder said, the industry will just have to deal with the ambiguity surrounding too big to fail and the competitive disadvantages it creates for banks that would not be rescued in the event of a failure.
The Yankees will always have a better baseball team than the Pittsburgh Pirates, and its not fair but that is just how it is, Mr. Blinder said.
