As we enter another week of the continuing credit crisis, I have begun too wonder if the critical mistake of the last few weeks was allowing Lehman to fail.   I do not envy the position that Federal Government is in.   On one hand they must let banks fail as it should not be the position of Government to backstop every failed business in America.  On the other hand, I do believe the Government has a role in ensuring the Economy operates smoothly.    When large banks fail, those failures run the risk of taking down the whole economy.  A single failure of a large enough bank has an ability to set off chain reaction that can cripple the whole banking system.    Was Lehman such a bank?  That I don’t know, but stock market certainly has not fared well since it’s demise.

Credit Crisis

Too Big To Fail?

Why are some banks too large to fail?  A bank has financial ties to not only other banks, but companies and individuals especially in today’s interconnected global markets.   Banks owe as money as they are owed, and in the case of failed bank they usually owe much more than than actually have.  As result when bank A fails it has the ability to take down Bank B and company C and start a chain reaction of failures in the economy.   A smaller bank can disappear without too much effect because its ties are limited.  The scope of larger Bank’s failure is often uncertain.  The network of ties are more numerous and interconnected.  The danger is not he first layer of credit obligations, but the nth connection and how those all tie back.   As a result Company C might be able to withstand Bank A’s failure, but not withstand Company Z’s failure which resulted from Bank X’s failure which resulted from Bank B’s demise.

Chain Reaction

Lehman

It’s strange that Government considered Bear Stears to big to fail, but not Lehman.  Lehman is arguably a much bigger bank with many more interconnections.  There’s no question that Lehman’s failure started a chain reaction.  Part of the reason that many Banks remain unwilling to lend is that they unsure of the risk their counterparties have with regards to Lehman assets.  Had the Government come to rescue, it would have faced credibility issues.  If the Government did not allow Lehman to fail, the question would have to be asked, “Is there any bank that’s too small to fail?”  The threat of failure needs to exist.