Brendan McDermid/Reuters

The CIT Group, one of the nation’s largest commercial lenders serving a million small and midsized companies, is on the verge of collapse now that federal officials have rebuffed pleas to rescue it with more taxpayer money. It had received $2.33 billion bailout from the feds in December.

The company’s failure would create a stark line between banks that the government deems too big to fail and those regarded as expendable. Some observers have pointed out that if Lehman Brothers had acquired CIT in 2002, when it was considering a deal, the two banks together would now be considered “too big to fail.”

Where should such a line be drawn? Does it send the wrong message to the banking sector when big banks are rescued when they engage in behavior that would otherwise be fatal for smaller institutions?

Make the Line More Clear

James D. Hamilton is a professor of economics at the University of California, San Diego.

If the government were to insure all the creditors of every failed financial institution, it would mean that the bank gets to keep any gains while the taxpayers are stuck with any losses. That creates incentives for the excessive risk-taking by private institutions that was one factor in causing the problems we currently face.

It’s not socially desirable to bail out every failed bank, nor is it fiscally feasible, so we have to draw the line somewhere. But for many of these institutions, the potential collateral damage to innocent bystanders from a financial collapse is sufficiently frightening that policymakers feel they need to step in to prevent further damage, despite concerns about the incentive problems that doing so may create.

So there is a process of fumbling around on a case-by-case basis as we try to figure out where to draw the line — prop up A.I.G., let Lehman and CIT go. Uncertainty about just who is going to be protected and who will be allowed to fail is yet another factor exacerbating the current instabilities.

Since there’s no easy way out once we face that decision, the obvious answer is to use regulation to prevent any private institution from putting us in a position where policymakers feel their only option is a public bailout. “Too big to fail” is, in my opinion, “too big.”

Too Many Bailouts, Not Too Few

Russell Roberts is a research fellow at Stanford University’s Hoover Institution and professor of economics at George Mason University. He is the host of EconTalk, a weekly award-winning podcast.



During the last 16 months, little justification has been provided for why some firms have been rescued while others have been allowed to fail. It is not healthy for a democracy to have hundreds of billions of taxpayer dollars go to highly wealthy individuals without a clear explanation for why such behavior is necessary in some instances but not others.

The two most prominent failures are Lehman Brothers and now, very likely, CIT. While CIT is relatively small, it is highly connected to many other businesses, particularly small businesses that depend on credit to manage their cash flow.

For decades, government policy and action have discouraged prudence by bailing out or taking over virtually every significant financial institution that has acted recklessly.

A similar justification was used for Bear Stearns’s takeover, A.I.G.’s total rescue, and G.M.’s lifeline. So why not save CIT? It is deeply disturbing that Lehman Brothers was a long-time competitor of Secretary Paulson’s former firm, Goldman Sachs. It is equally disturbing that the chief executive of CIT, Jeffrey Peek, has been a contributor to Republicans rather than Democrats. This could be mere coincidence. But the current and ad hoc bailout strategy inevitably creates suspicion and destroys faith in our economic and political system.

The bigger mistake has been the bailing out of too many firms rather than too few. Capitalism is a profit and loss system. The profits encourage risk-taking. The losses encourage prudence. For decades, government policy and action have discouraged prudence by bailing out or taking over virtually every significant financial institution that has acted recklessly.

Five years ago, well before the crisis, Gary Stern and Ron Feldman of the Minneapolis Fed, wrote “Too Big to Fail,” arguing that the continual rescue of debt holders and creditors was creating systemic risk in the financial system.

They pointed out the crucial role that debt holders and creditors play in monitoring and restraining risky investments on the part of financial institutions. By consistently bailing out creditors, the power of that restraint was being destroyed. They argued that we were encouraging excessive risk-taking and destroying the natural feedback loops of prudence that would otherwise restrain bad behavior.

They were right, but no one listened. The same mistakes continue. The ongoing rescue of virtually all creditors and counterparties of insolvent firms, rewards recklessness, creates an impression if not the reality of crony capitalism, and sows the seeds for the next financial crisis.





Bondholders Should Take the Risk

Mark A. Calabria is a former member of the senior professional staff of the Senate Committee on Banking, Housing and Urban Affairs, is director of financial regulation studies, Cato Institute.

The trouble with rescuing some institutions (those within the favored circle of political protection) is that they get to enjoy lower funding costs — with a related reduction in market discipline. Of course, there are proposals for more oversight and regulation for institutions, whose existence is deemed important for the health of the entire financial system. But the truth is, any additional regulation won’t offset the advantages of having the backing of government money.

The only sure way to end these inequality is to end “too big to fail” taxpayer support permanently. The fact is, no bank is too large to fail, although some may be too large to resolve or re-organize in a quick and clean manner. For those banks, a special bankruptcy court should be established to resolve these entities with greater certainty, and with no injection of taxpayer funds.

We should recognize that “too big to fail” is more a political problem than an economic one.

Equally important, we should recognize that “too big to fail” is more a political problem than an economic one. The ability of the Fed and the Treasury to place hundreds of billions of taxpayer funds at risk must be limited, if not abolished outright.

Whenever a corporation becomes insolvent, the fundamental question is: who will bear the losses? In the bailouts of A.I.G., Bear Stearns, Fannie, Freddie and the auto companies, the choice was made that the taxpayer would come to the rescue.

There is another deep pocket involved in all these companies: their bondholders. In a highly leveraged institution, the only real discipline comes from the market. While imposing losses on creditors will raise the cost of debt, it is not only appropriate, but necessary. After all, artificially cheap debt contributed to our financial crisis.

We do not need to draw a line between the treatment of large, medium and small banks. We need to erase the existing political boundary that favors some while leaving others to fail. All institutions have to be open to failure — it is the reason why markets work.