Financial Firm Bankruptcy and Systemic Risk

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