6
“Too Big to Fail” before the Fed
The term “too big to fail” was coined by Congressman Stewart McKinney (of Connecticut; 1981– 87) in reference to the 1984 rescue of Continental Illinois Bank.1 Continental Illinois failed as a result of its exposure to a downstream bank, Penn Square, which had losses on oil-related speculations. The failure occurred in the larger context of the Latin American debt crisis (1983 – 89), and FDIC chairman William Isaac and Federal Reserve chairman Paul Volcker argued that the failure of Continental would have led to runs on other large US banks (see Kaufman 2004 for details). The failure of Continental was the largest bank failure in US history prior to the financial crisis of 2007– 8. In fact, the failure of Continental involved a run by uninsured wholesale creditors—an omen for the events of 2007– 8, which involved such creditors on a massive scale. In the years since the Continental Illinois failure, banks have allegedly engaged in taking risks greater than they otherwise would because of a belief that they would be bailed out by the government, possibly causing or contributing to the financial crisis of 2007– 8, because large banks believe they are too big to fail. In this chapter we revisit this issue by studying the National Banking Era, a period in which large banks were considered too big to fail and hence were rescued by other large banks. In the modern era it has been hard to find evidence that large banks are the beneficiaries of implicit too-big-to-fail government policies and become riskier as a result. Beck, Demirgüç-Kunt, and Levine (2006) studied sixtynine countries from 1980 to 1997 and found that more concentrated banking systems are less likely to have financial crises, controlling for differences in bank regulations, national institutions affecting competition, and macroeconomic conditions (also see Evrensel 2008 on this point). Ahmed, Anderson, and Zarutskie (2015) have found that credit derivative spreads are no more
