How Big Banks Fail

... and What to Do about It, Darrell Duffie, Princeton University Press.

Run-of-the-mill commercial banks fail almost every week, and most Americans are well aware of the regulatory tools that address the social costs of bank failure—FDIC deposit insurance, for example. But when it comes to major dealer banks—often described as large complex financial institutions or too big to fail—it can be difficult to get a handle on how these banks operate, much less how they fail.

In “How Big Banks Fail,” Darrell Duffie—Dean Witter Distinguished Professor of Finance at Stanford University’s Graduate School of Business—describes the failure mechanics of dealer banks, explaining how (and why) a major dealer bank might suddenly transition from weakness to failure. He also suggests regulatory improvements that would reduce the risk of a major dealer bank failure—and the damage done if one fails. Finally, he imparts lessons to be learned from major dealers such as Morgan Stanley that did not fail despite severe stresses on their liquidity shortly after the Lehman [Brothers] bankruptcy in 2008.

Much of “How Big Banks Fail” is accessible, but parts of the 61 pages of text are probably beyond the comprehension of the casual reader. Yet it is worth attempting to digest the book’s contents, as Duffie reveals why current regulatory and institutional frameworks for mitigating large-bank failures don’t adequately address the risks to our financial system. And make no mistake: the failure of another dealer bank would pose a significant risk to both the financial system and the wider economy.