Recent U.S. history highlights the tension between large-scale public bailouts and political backlash.
A crucial episode dates to 1984, when doubts emerged about the value of Continental Illinois Bank’s large commercial and industrial lending operation. That spooked wholesale creditors and depositors, who rapidly withdrew their funds. The FDIC decided that, due to Continental Illinois’ size and connections to other major financial institutions, it was necessary to ensure deposits without limit and make all creditors whole. This decision produced what was then the most expensive taxpayer bailout in the history of deposit insurance.
The episode led to congressional hearings in front of an angry House Committee on Banking, Finance and Urban Affairs. Rep. Fernand St Germain (D-R.I.), who chaired the committee, charged that “the FDIC and the Federal Reserve have created, without congressional approval, a brand-new entitlement program for money center banks.” This scorn was bipartisan. Rep. Stewart McKinney (R-Conn.) famously declared: “We have a new kind of bank. It is called too big to fail. TBTF, and it is a wonderful bank.”
Despite this backlash, Congress continued to deregulate the financial system, hoping to spur the economy to come back from the stagflation of the 1970s and fitting with the ethos of President Ronald Reagan’s drive to reduce government and unleash business. But while deregulation enabled financial institutions to continue to expand their reach — it also created greater risk that banks would fail, thereby necessitating the very bailouts that lawmakers derided.
Yet, lawmakers had little incentive to change anything. They were free to spur the economy, knowing that if government bailouts followed, they could moan about the unfair imposition on taxpayers, while regulators — from agencies like the Federal Reserve and FDIC, who were insulated from the political process — would undertake the bailouts anyway, to protect the financial system. It was a win-win for elected politicians.
After the Continental Illinois failure, Federal Reserve Chair Alan Greenspan (1987-2006) became convinced that the relevant public institutions could not let big, interconnected financial companies fail. As chair of the Fed, he acted with that belief in mind, helping to orchestrate a massive public bailout of $160 billion (of which $132 billion was paid for by taxpayers) during the savings and loan crisis of 1989. Regulatory entities, led by the Fed and the FDIC, also established an increasingly wide net of insurance for markets.