Let 'em Fail
By Arnold Kling
it is my view that only the failure of a large commercial bank can create a systemic breakdown, and that nonbank financial firms–even large ones–are no more likely than GM to have this effect. For that reason, I would not designate any nonbank financial institution (other than a commercial bank) as systemically important, nor recommend safety and soundness supervision of any financial institutions other than those where market discipline has been impaired because they are backed by the government, explicitly or implicitly.
…As support for its proposal, the administration cites the “disorderly” bailout of AIG and the market’s panicked reaction to the failure of Lehman Brothers. On examination, these examples turn out to be misplaced. Academic studies after both events show that the market’s reaction to both was far more muted than the administration suggests. Moreover, the absence of any recognizable systemic fallout from the Lehman bankruptcy–with the exception of a single money market mutual fund, no other firm has reported or shown any serious adverse effects–provides strong evidence that in normal market conditions the reaction to Lehman’s failure would not have been any different from the reaction to the failure of any large company. These facts do not support the notion that a special resolution mechanism is necessary for any financial institutions other than banks.
Read the whole thing. I would like to believe that Wallison is right (and I have no evidence that he is wrong). If he is right, then we can implement at least part of what I advocated yesterday, when I said that under my preferred regime, “As long as you’re not a bank, you are free to fail any way you like.”
Those who disagree with Wallison and me need to spell out their arguments.