Financial Firm Bankruptcy and Systemic Risk

6 Pages Posted: 14 Jul 2009

Multiple version iconThere are 2 versions of this paper

Date Written: June 21, 2009

Abstract

Policymakers justify bailing out major financial firms by saying those firms are 'too big to fail.' They argue that such failure would subject the market to 'counterparty contagion' as the failed firms default on their obligations to other firms. But empirical evidence indicates that counterparty contagion is rarely at work in the financial world, as investors diversify their risks. On the other hand, the current crisis does appear to reflect 'information contagion,' where the failure of one firm reveals the instability of similarly positioned firms. Information contagion cannot be contained by a bailout of 'too big to fail' firms, but instead requires a broad government bailout of the broader financial industry. Such a bailout would only reward the least successful companies and prevent the better-run firms from gaining market share. Policymakers should abandon the notion that the major financial firms are 'too big to fail' and let them unwind their toxic assets through the orderly bankruptcy process.

Keywords: TBTF, To Big to Fail, financial contagion, financial crisis, information contagion, counterparty contagion, SIPA

JEL Classification: D84, E32, G10, G18, G20, G28, H32, H81

Suggested Citation

Helwege, Jean, Financial Firm Bankruptcy and Systemic Risk (June 21, 2009). Regulation, Vol. 32, No. 2, pp. 24-29, Summer 2009. Available at SSRN: https://ssrn.com/abstract=1432454

Jean Helwege (Contact Author)

UC Riverside ( email )

900 University Ave.
Anderson Hall
Riverside, CA 92521
United States
9518274284 (Phone)

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