Living Wills: A Tool For Curbing “Too Big To Fail”

by Richmond Fed

Although the financial crisis of 2007 – 08 is gradually receding into history, policymakers and the public are still concerned about avoiding a repetition of the crisis. At issue is not only the economic dislocation that arose from the crisis, but also the public bailouts of major financial institutions such as Bear Stearns and AIG that became financially distressed and were then considered “too big to fail”.

These rescues – seen by many as a distasteful brew of private risk-taking and socialized losses – seem to have been in part the outcome of an expectation that policymakers brought about with a series of rescue operations and other interventions going back to the 1970s. Two examples of these are the Fed’s support for Continental Illinois National Bank and Trust Co. in 1984 and the Fed’s use of its “good ošces” to save the hedge fund LongTerm Capital Management in 1998. Such actions are likely to have created a belief in the markets that some institutions are, in fact, too big to fail. Hence, despite an intention to stabilize the financial system, the implied promise of rescue may have actually induced fragility in financial markets through a circle of rescue and failure.

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Source: http://www.richmondfed.org/publications/research/annual_report/2014/pdf/article.pdf