Economics of Contempt has an almost undescribably good post up on the problem of "To Big to Fail" resolution proposals. I was having dinner with a friend from business school last night, and we talked about this quite a bit--and the more we talked, the more complications we found.

The problem is that "too big to fail" isn't about the size of a bank's balance sheet; it's about how tightly coupled that balance sheet is with other institutions. The FDIC can resolve even a huge conventional commercial bank, because as long as the loans are sold and the depositors paid off, that failure doesn't suddenly and massively impair other peoples' balance sheets.

(It may, down the road, if for example a huge portfolio of real estate loans is written down, which casts doubt on the value of the collateral securing the loan books of other banks. But that's different from triggering a bank run.)

It is pretty clear to me that the Fed and Treasury decided to let Lehman (or whatever bank tottered next, rather) fail, pour encourager les autres--and that despite months of preparation, they didn't foresee the meltdown in the money markets that this failure touched off. Hence all the subsequent bailouts: no one could be quite sure what the fallout from further failures might be.