Almost every Friday since January, the Federal Deposit Insurance Corporation (FDIC) has added more names to its “failed bank list”—84 so far this year, already more than the 26 for all of 2008. America should be proud of this document, which seems an example of the prudent regulation integral to free markets. But the FDIC’s elegant system, which both ratifies the markets’ discipline of bad banks and protects broader markets from depositor panic, has become a tool of the government distortion that imperils our competitive economy.

Since 1933, people who deposit money in American banks have relied on a guarantee: if their accounts are below a certain amount (today, $250,000) and their bank fails, they won’t lose a dime. The FDIC provides this protection through fees that it levies on banks, though it can access taxpayer money if it falls short, as it soon may. But though the FDIC insulates small depositors from market discipline, the agency is also the government’s instrument of market discipline when it comes to banks’ investors, who take losses, if warranted, when a bank fails. Under a consistent, predictable order set by statute, shareholders bear the brunt of such losses, followed by bondholders, general creditors (such as vendors with unpaid bills), and uninsured depositors along with the FDIC itself.

The details of the FDIC’s failure roll appear to show American capitalism in action, along with the government’s role of trying to ensure free, fair competition. Tiny banks—like Oklahoma’s First State Bank of Altus, with $103 million in assets—take risks, stumble, and fail. Often, other small banks, such as Herring Bank in Altus’s case, take over in a quest for growth.

In theory, the system offers large banks no refuge. Last year, two months before the September collapse of Lehman Brothers, the FDIC oversaw the failure of IndyMac, with $32 billion in assets. The California bank’s investors, including uninsured depositors, found themselves exposed to loss, as they should have been. Less than two weeks after Lehman fell, the FDIC presided over the failure of Washington Mutual, which had $307 billion in assets (though JPMorgan Chase chose to protect uninsured depositors in its purchase of WaMu).

Unfortunately, the system has been overpowered by banks that have become, in the government’s view, “too big to fail.” Rather than mustering the courage to act in the national interest and address this problem, the big banks’ political handmaidens have chosen to enjoy the favors offered by an increasingly concentrated financial industry, helping to create the conditions for the 2008 financial crisis. Last year, at the height of the financial crisis, the White House and the Federal Reserve largely followed the too-big-to-fail doctrine, and the FDIC aided them, partnering with the Treasury and the Fed to provide $306 billion worth of “assistance” to Citigroup in the form of guarantees against losses. The government offered a similar deal to Bank of America.

Too-big-to-fail is more alive than ever. In fact, the financial crisis has shown just how valuable the government’s implicit guarantee of big banks is: according to FDIC data, banks with $100 billion–plus in assets can borrow at rates one-third of a percentage point lower than the rate available to smaller banks. That’s more than quadruple the advantage they enjoyed pre-crisis, and a mark of lenders’ confidence that the government will protect them. As FDIC chairman Sheila Bair wrote in Tuesday’s New York Times, the government lacks “a credible method for closing large financial institutions without inflicting severe collateral damage on the economy.” By contrast, Bair wrote, “Main Street banks”—smaller banks, that is—“are sensitive to market discipline because they know that they’re not too big to fail and that they’ll be closed if they become insolvent.”

Until President Obama and Congress end too-big-to-fail, the smaller banks currently succumbing to market discipline will only provide fodder for the part of the system that’s out of control. This disaster is unfolding now, because hundreds more small banks will probably fail in the next year or so, hurt by losses on commercial real estate and prime mortgages, among other investments. Every bank that goes under can be swallowed up by a bigger bank, just as JPMorgan Chase digested WaMu. Too-big-to-fail is also an incentive for small banks to buy other small banks, even when the purchase is unwise—trying to beef themselves up to compete with their gigantic, government-subsidized rivals.

Options abound as to how to end too-big-to-fail. Congress and regulators could design a system that would prevent regulators, in the future, from offering a bank like Citigroup guarantees against losses. Instead, regulators could take the bank into temporary administration and spin off its threatened assets into a “bad bank.” Shareholders and then uninsured creditors, including bondholders, would take their hits for the assets’ losses, in the consistent, predictable fashion that free markets rely on.

Instead, though, the White House has offered proposals that could make things even worse. For instance, Treasury secretary Tim Geithner wants to make banking regulation the province of a single, monolithic regulator. Bair worries that such a regulator would “inevitably benefit the largest banks” with its “resources and attention,” creating “more consolidation . . . at a time when we need to reduce our reliance on large financial institutions and put an end to the idea that certain banks are too big to fail.” It’s easy to see how. The biggest banks would be the most adept at capturing regulators, because their leaders, lobbyists, employees, and former employees help shape the Washington culture. Further, because of proximity and familiar thinking, a monolithic bank regulator, the next time it makes a systemically catastrophic mistake, is likely to do so in a way that benefits the big banks.

The FDIC’s growing list of failed banks shows that the too-big-to-fail doctrine is not a static problem that Obama and Congress can tackle halfheartedly, perhaps hoping that the financial crisis fades from memory before the politicians and regulators can agree on anything. As the list grows, too-big-to-fail and the market and economic distortions it creates grow, too—making the problem even harder to fix.


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