Too Big to Fail

Foreword by Paul A. Volcker

Whether bank failures caused the Great Depression, or vice versa, is still unclear. However, the fact that both occurred together has persuaded policymakers that bank failures have potentially disastrous consequences for the economy. For years leading up to the Great Depression, banks were somewhat regulated and central banks were the acknowledged “lenders of last resort.” However, central banks lent only to fundamentally sound institutions with collateral. The Great Depression led to the establishment of the Federal Deposit Insurance Corporation (FDIC), and to an understanding that government regulators would act to prevent or mitigate bank failures.

In the 1970s, financial deregulation, competition and new economic conditions set the stage for expanded government safeguards against bank failure. The results included the rescue of Continental Illinois Bank, the protection of savings and loan deposits, and tacit acknowledgment by policymakers that some institutions were so crucial that their failure would endanger the entire financial system. Smaller institutions, which regulators exclude from their implicit promise of financial bailout, ...