Economics Working Paper 18120
Abstract: Leading up the crisis, the core of the financial system was not prepared to withstand a significant shock. An undue reliance by regulators on market discipline had left the largest financial firms undercapitalized. This was exacerbated by a failure of the SEC to prioritize financial stability. Core financial firms were actually encouraged, through artificially low costs of debt financing, to use leverage to grow enormous balance sheets. Creditors competed to supply these firms with funding at razor thin credit spreads because they appeared to believe that these firms would not be allowed by the government to fail. Their belief in “too big to fail” was based on the presumption of large spillover costs of failure on the broader economy. This presumption was correct. When Lehman actually did fail, it was impossible to avoid enormous bankruptcy costs and contagion because safe insolvency resolution tools for large banks had not been developed.