Too Big To Fail: The Hazards of Bank Bailouts

Moral hazard is one of the most basic concepts in economics: If someone pays you for your accidents, you will expend less effort trying to avoid them. Insurance companies understand this perfectly well. That's why most insurance contracts include customer deductibles and limited coverage. This seems straightforward enough. Why is it, then, that policymakers appear to have missed this important lesson? In Too Big To Fail, Bank of Minneapolis Fed President Gary Stern and Vice President Ron Feldman examine this question in the context of government policy towards bank failures. Written for policymakers, this short book lucidly explains the moral hazard problem that plagues large financial institutions policymakers deem " too big to fail " (TBTF). Why might some banks receive this privileged status? If a bank has many customers or plays a large role in the nation's financial system—for instance, by processing many of the nation's payments or security transactions—its failure may threaten the solvency of other institutions financially connected to it and to each other. By creating a domino effect, the failure of a TBTF bank threatens to cripple the national economy. For instance, if a major bank fails, and other banks rely upon this bank and its creditors to fulfill their obligations to function, then these banks too, and potentially those institutions they are financially connected to, may collapse as well. If the spillover effects generated via this process are large enough, the failure of a big bank could trigger an economy-wide recession.