Why Were 12 Out of 13 Major Banks on the Brink?

Since the Financial Crisis Inquiry Commission released its report yesterday, there's been some interest about a comment Federal Reserve Chairman Ben Bernanke made during a private interview with the commission. He said that 12 of the 13 most important financial institutions were at risk of failure during the crisis. It's important to take this comment into context, and not jump to the wrong conclusion.

First, let's go to the comment itself:

"As a scholar of the Great Depression, I honestly believe that September and October of 2008 was the worst financial crisis in global history, including the Great Depression. If you look at the firms that came under pressure in that period . . . only one . . . was not at serious risk of failure. . . . So out of maybe the 13, 13 of the most important financial institutions in the United States, 12 were at risk of failure within a period of a week or two."

John Carney at CNBC speculates about who these firms might have been, but is right to consider this a fool's errand. Bernanke should just tell us. After all, at this point, they've all pretty much recovered anyway. There's little point for us to try to imagine which of the firms were on this list, and which one might have survived. In fact, who they were doesn't really matter.

Instead, it's also important to consider what Bernanke's comment does and doesn't mean. Bernanke is not saying that 12 of the 13 most important financial institutions were fundamentally poisoned and deserved to fail. He says that, in fact, 12 of 13 would have failed due to the historic credit crunch that was underway. In other words, this was a practical reality due to the panic that had gripped the market, not a deserved verdict on banks due to flawed balance sheets that were beyond repair.

This is an important point. Many people still hold a common misconception that most banks were rescued even though they really ought to have failed due to the big losses they incurred. Although some banks' assets did get hit with huge losses, in most cases those losses would not have nearly wiped out all of their assets. Their near failure resulted from not being able to roll over their debt. Their problems were panic-driven.

Yet these banks did almost fail, and that demonstrates a key problem that they shared: too much leverage, too much of which was based on short-term debt. If these banks had more stable funding strategies in place, then they would have simply endured their mortgage-related losses as they hit over the course of several years. The losses might have been large, but if their debt levels were more moderate and turned over every few years instead of every few days or weeks, then failure wouldn't have been likely.

And that's a way to translate what Bernanke was really saying. Of the 13 major institutions 12 had too much debt that turned over so quickly that they nearly failed due to the credit crunch. While the new Basel III capital requirements take some steps to try to fix this problem, its importance can't be overemphasized. If these banks had less leverage and less short-term debt in particular, then the financial crisis probably would never have occurred and the bailouts would have been unnecessary.