The world is well aware that it needs an exit strategy from the massive monetary and fiscal stimulus that started in the final months of 2008. But we also need an exit strategy from too big to fail. It is simply too costly to continue.
In October 2008 – in the wake of the panic that gripped financial markets following the failure of Lehman Brothers – governments promised that no systemically important institution would be allowed to fail. Governments backed up that promise by recapitalising major institutions. Providing this backstop was just as important as monetary and fiscal stimulus in arresting the slide in the real economy. Instead of the Great(er) Depression, the year 2009 turned into the Great Recession. But, for two reasons, it may be unsustainable for governments to continue to promise that no systemically important institution will be allowed to fail. First, it removes market discipline from such institutions. That increases the probability that systemically important institutions overstretch themselves such that governments will be required to perform on their guarantee. Second, the promise may be unsustainable simply because of the potential expense involved. Even if countries were willing to stand behind these liabilities, they may not find the means to do so.
Arguably, that is exactly what happened in the case of Lehman. The market expected the US government to bail out Lehman. When it did not, chaos resulted. Spreads on bank funding surged. Liquidity contracted and further failures followed. The global economy went into free fall.