The decision to stand behind uninsured deposits by the Fed, Treasury, and the FDIC announced on Sunday, March 12, I believe was necessary and correct.
It has been probable since the aftermath of Lehman Brothers, however, that any reasonably large systematically connected depository institution (and some non-depository institutions) could potentially trigger a systemwide bank run. You will recall that private investment into the U.S. banking sector during the Financial Crisis of 2007-2009 ran to the tens of billions of dollars immediately prior to the decision in mid-2008 not to stand behind Lehman. You will also recall that immediately after that decision was taken, investment in the banking sector became essentially zero. Lehman filed for bankruptcy in September of 2008. This single event ultimately led to TARP and other measures to keep the system afloat at an enormous cost to the country both financially and economically. While we are not out of the woods yet, it seems likely that we will not need to go there this time.
But where do we go? Reliance on large depositors to police risk at banks is a myth, a myth that should finally be put out to pasture. It is a theory that does not withstand market testing and cannot stand up to systematic risk at today’s complex financial institutions.
As a JD/MBA student at the University of Chicago, I became interested in bank failure. I wrote a thesis for the Specialization of Finance designation at the Business School on the topic of the 1984 collapse of Continental Bank N.A. I didn’t fully appreciate at the time that the nature of the financial markets and the regulation thereof would lead to increasingly more difficult to contain crises. As a lawyer major “crisis” engagements started in 1998 with the subprime meltdown and the Russian bond defaults. Eight years later the Financial Crisis of 2007-2009 followed. At that time, I represented GMAC Residential Capital, with a balance sheet of $120 billion of mostly complicated subprime mortgage-backed securities. ResCap performed a necessary intermediation much like Fannie and Freddie do for prime mortgages. We were able to put that enormous balance sheet into an orderly liquidation, the final remnants of which are still wrapping up. My firm and I at the time also represented U.S. and European money center banks, funds, and other financial institutions and specialty lenders. Some were saved, some with spectacular results.
And here we are again at the doorstep of another crisis. This time, likely averted by the ghost of Lehman Brothers past.
More thinking is required. Thinking about how to build and install appropriate circuit breakers without reducing the innovation in the financial and tech sectors in particular, but in the economy in general, that is the lifeblood of our economy.