Tuesday, 25 October 2011

Is "Too Big To Fail" too big to end?

The short answer seems to be yes, for Korea at least.
Can a government credibly promise not to bailout firms whose failure would have major negative systemic consequences? Our analysis of Korea's 1997-99 crisis, suggests an answer: No. Despite a general "no bailout" policy during the crisis, the largest Korean corporate groups (chaebol) - facing severe financial and governance problems - could still borrow heavily from households through issuing bonds at prices implying very low expected default risk. The evidence suggests "too big to fail" beliefs were not eliminated by government promises, presumably because investors believed that this policy was not time consistent. Subsequent government handling of potential and actual defaults by Daewoo and Hyundai confirmed the market view that creditors would be protected.
This is from a new NBER working paper, Ending "Too Big To Fail": Government Promises vs. Investor Perceptions by Todd A. Gormley, Simon Johnson and Changyong Rhee.

But is anyone really surprised that people don't believe what politicians tell them? A no bailout policy is not credible given the way governments have acted in the past. To make such a policy work governments really do have to let big firms fail.

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