CIT Group: Too Small to Save -- Or Not

Does CIT Group illustrate the perils of being too small to save?

The chatter over the weekend was that the federal government is refusing to lend the company money under its Temporary Liquidity Guarantee Program. That prompted CIT to hire law firm Skadden, Arps, Slate, Meagher & Flom, according to the WSJ, stirring speculation that the company may be headed for bankruptcy. CIT on Sunday said in a statement that it "remains in active discussions with its principal regulators on a series of measures to improve the company's near-term liquidity position."

The lender's fate remains up in the air, with some reports that its customers are scrambling to draw down on their lines of credit, while other outlets said a deal with the government is imminent.

CIT's woes highlights just how squishy the concept of "systemic" importance really is where financial institutions are concerned. We know some players are too big to fail. AIG? Systemically risky. Citigroup, you bet. Lehman Brothers... okay, in retrospect that one probably passes the grade, too.

The company's travails also reveal an uncomfortable truth. Everyone knows that the collapse of major banks and other lending institutions can wreak havoc that cascades into the economy at large. But no one, including economists and government regulators, knows exactly what a systemically risky company looks like. Size matters, of course, but it's not everything. Many other factors count, such as the extent of a financial company's counterparties, levels of exposure and capital structure, along with more amorphous concerns, such as the psychology of investors.

The fact is that there is no set procedure for regulators to identify systemic risk, like the doctor rapping your knee with a rubber mallet. Rather, their approach is closer to former Supreme Court Justice Potter Stewart's famous test for defining pornography -- you know it when you see it. That's key to the ongoing debate over financial reform, because an ability to sniff out systemic risk is central to the question of how the government should regulate banks. By extension, it also affects the Obama administration's plan to let the Fed manage risk. Peel the onion some more and you'll find a related question lurking deep within the financial system, which relates to how risk should best be allocated around different institutions.

Clearly, by some criteria CIT matters. The company has some $75 billion in assets, which would make its bankruptcy the biggest since Washington Mutual blew up last fall. CIT, which specializes in lending money to small and midsize businesses, contends that its demise poses a systemic danger because that would jeopardize 760 of its manufacturing customers and cause serious harm to more than 300,000 retailers, according to Bloomberg.

The FDIC, which administers the government's temporary-liquidity program, seems to disagree. And that's because, ultimately, systemic importance is a hypothesis. It's a best guess by regulators that this company, and not that one, could topple the dominoes if allowed to tip over. In CIT's case, the FDIC may be content to let it fall.

For a different view of CIT, check out this CBS MoneyWatch post by my colleague John Keefe.