296 The Management of Bond Investments and Trading of Debt
The way it was reported at the time, there had been disagreements among the
federal bank regulators – the FDIC, Comptroller of the Currency (OCC), which
regulates federally chartered banks, and Federal Reserve Board – over how to handle
the Penn Square problem. These disagreements are a good example of the dilemma
facing regulators on whether to allow good money to run after bad.
The Fed and the OCC seem to have opposed closing the bank, but William M. Isaacs,
the FDIC chairman, prevailed. Sources at Wall Street added that the Federal Reserve was
concerned about the uninsured depositors – which were primarily other depository insti-
tutions such as commercial banks, savings and loan associations and credit unions – and
the effect the bankruptcy of Penn Square would have on them. As subsequent events
proved, this concern was real. But the question remains: should taxpayers’ money be
used to save dreadfully mismanaged banks from failure?
13.4 Commercial paper turning to ashes: the case of Penn
The classical form of financial crisis starts when the sudden failure of a major bank,
or group of banks, leads traders and investors to refuse to deal with other institutions
thought to have similar vulnerabilities. The same is true about dealing with other
banks engaged in markets disrupted by the failure of a major credit institution or
industrial organization. This is particularly true if:
The failed firm is a member of one of the settlement and payment systems, and
Its failure may cause disruptions to other firms in the system, or a broader systemic
What has been stated about banks is also valid of debt instruments issued by
overleveraged entities that find it difficult to stay alive. An often cited example is the
failure of Penn Central Railroad in 1970, which precipitated a crisis of confidence in
the US commercial paper market. This made it more difficult for other commercial
paper issuers to roll over their maturing debt.
Among well-managed financial institutions, many view firms with large commer-
cial paper outstandings as potential sources of systemic risk. Underlying this negative
reaction is the speed with which commercial paper funding can evaporate. There is a
fashion in everything. US securities firms, for instance, reduced their reliance on the
commercial paper market in the wake of the Drexel and Salomon affairs.
In a similar way, a liquidity crisis in a large financial firm could grow into a solvency
crisis if uncertainty about the severity of outstanding problems, and other conditions
relating to the entity, leads counterparties to cut off funding channels. Or, to refuse to
enter into transactions which the company needs to manage its exposure.
In theory, creditors should be willing to lend to an illiquid, but solvent, institution.
In practice, the lending may not occur because creditors cannot determine rapidly
enough the true extent of difficulties.

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