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National Review Online


Credit in the Real World

September 26, 2009

By Nicole Gelinas

The conventional wisdom holds that nobody likes the “Too Big To Fail” doctrine that has governed the financial system for the past 25 years. But — the supposedly responsible pragmatists say — it’s just something with which we have to live, because there’s no real-life way to force lenders to big financial institutions to take their losses without causing unacceptable global chaos.

The reality, though, shows something different. Last week, the Moody’s credit-rating firm told investors what it thinks of the British government’s idea to require banks to draw up “living wills” and periodically update them, the Financial Times reported. In such a document, a bank would instruct regulators on how best to wind down the company in event of failure. Regulators would use the will to assess whether a company’s plan for failure was technically feasible, and, if not, could ask financial firms to take steps to make it more so.

The “living wills” couldn’t prepare regulators for every eventuality. But the wills would be credible evidence that the government is trying its best to avoid bailing out big or complex financial firms in the future.

Moody’s seems to think so. In its report, it discussed the possibility, from investors’ perspective, that a requirement for living wills “would remove the necessity [for governments] to support banks as banks would no longer be too interconnected or complex to fail. This could potentially result in rating downgrades where ratings currently incorporate a high degree of government support.”

Roughly speaking, lower ratings mean higher interest rates, which would make it harder for firms to grow so big and complex in the first place.

We’ve had “too big to fail” for a long time, and financial firms and their investors have gotten used to this government support. For decades, the government has subsidized size and complexity in the financial world. Unsurprisingly, the markets provided the feds with more such size and complexity in the financial industry, making the subsidy seem even more vital as banks and other financial firms grew even more unwieldy.

But we haven’t had Too Big To Fail forever. As the Moody’s report suggests, markets could once again grow accustomed to discipline, with investors adjusting their lending to big banks as they reconsider the risk.

It’s up to the government, though, to find the political will to create a consistent, predictable system for enforcing such discipline.

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