An insider’s view of the political economy of the too big to fail doctrine

Understanding interbank exposure is the key to understanding the too big to fail doctrine. In this paper, the authors present arguments supporting three principal hypotheses: high levels of interbank exposure reduce the safety and soundness of the banking system; interbank exposure affects the ability to the Federal Deposit Insurance Corporation (FDIC) and bank regulators to use market discipline as a constraint on banks’ risk-taking; and a rising level of interbank exposure is indicative of reduced stability of the financial system. In addition, they provide evidence that interbank exposure does not, at this time, appear to be a generalized problem for U.S. banks; however, some banks in all categories of asset size still have comparatively high ratios of interbank exposure to capital, despite a general decline in these ratios since the Continental Illinois failure.