AIG was not too big to fail, but too connected. Bankruptcy would quite probably have voided the debt insurance that AIG provided, triggering emergency capital raisings from counterparties around the world. The Fed’s rescue is on punishing terms: AIG must repay the $85bn loan at a storecard-like 8.5 percentage points over Libor, liquidating perfectly fine assets to do so. But resolution – of a sort – has been achieved.

Meantime, chalk this up to a failure of regulation. AIG was laid low by marked-to-market losses in its financial products division, which wrote insurance on fixed-income securities held by banks. But what AIGFP offered was not straightforward protection, in the sense of covering for potential losses. It was regulatory arbitrage. Banks that entered credit default swaps with AIGFP could assure auditors and regulators that the risk of the underlying asset going bad was protected, and with a triple A rated counterparty.

Under international rules on capital adequacy, the banks were therefore allowed to hold less cash in reserve. The ability to deploy that freed-up cash was worth more than the cost of the premiums paid over the life of the CDS. All this is within the rules: in a recent 10-Q filing, AIG made no secret that FP had been built “to provide regulatory capital relief rather than risk mitigation”. But it should not have been beyond the wit of the Basel II committee to see that dangerous levels of counterparty risk would accumulate in institutions willing, as AIGFP was, to write insurance on very attractive terms.

As CreditSights notes, the Fed’s rescue package has been delicately crafted to avoid any of the terms that might trip a CDS. Regulators are still tiptoeing around instruments they barely understand. The AIG implosion should result in much higher risk-weightings for CDS contracts. That will create further capital pressures for banks, at the worst possible time. Tough.