No Silver Bullet for “Too Big to Fail”

Whether to use public money to rescue financial firms because they are too big, too complex, or too interconnected to be allowed to fail is not a new issue. However, in the financial and economic crisis of the last year and a half, the number and nature of such rescues in sophisticated financial markets and systems has dramatically increased the salience of the issue. It is summarized by the initials “TBTF,” or “too big to fail.” Precedents have been set. There is an understandable desire to limit the application of those precedents. The US Congress is considering remedies to impose such limits in the future. Each remedy comes with costs or with problems. No silver bullet will solve this problem. A combination of steps will be required.

The TBTF issue in the US context is, first, a political issue. Citizens and their representatives see as unfair the “bailouts,” or rescues, of large financial institutions using financial resources that ultimately are provided by the taxpayers. They see Wall Street being bailed out by Main Street.

Certainly, going forward, the status quo prior to the crisis is not a viable option not only because of taxpayer revolt but also because of moral hazard considerations that were highlighted and exacerbated by government actions in the crisis. The impacts on the behavior of institutions that are not allowed to fail, or the behavior of their management, are more important than the issue of the cost of bailouts and who bears those costs. Size is just one ingredient in this calculus; the more important ingredient is the lack of the potential to fail. Moral hazard surely will affect behavior in the future even if it did not do so in the past.

If governments are expected to protect private institutions from failure, market discipline will be undermined along with what Schumpeter referred to as the desirable process of creative destruction. Competition is distorted. Capital is misallocated. Poor risk management or, if you like, the taking of excessive risk is rewarded. Losses are socialized. This is where the taxpayers come in, but those losses are only part of the equation. Implicitly or explicitly, governments are injected into the management of financial institutions. This changes the rules of the game. One result is a more concentrated structure of financial entities, more prone to take excessive risk and with little evidence of societal benefits, such as increased efficiency, lower costs, or greater availability of credit.

In the United States, remedies for the TBTF problem fall into four categories of proposals: (1) break up the systemically important institutions so that individually they are not too big and the consequences of any failure are eliminated; (2) separate riskier activities into unrelated institutions whose failure will not have the same direct adverse consequences for the economy and the financial system; (3) employ a combination of regulatory modifications that either discourage excessive risk taking or establish cushions against its consequences; or (4) establish a special resolution mechanism so that the failure of systemically important financial institutions can be managed to minimize the damage to the financial system and economy without the need for a governmental rescue.

Each of these remedies has its merits and supporters, but also its problems and detractors.

The problems with the first category of remedies—the breakup approach—are several. This approach involves more than downsizing institutions by reducing their work forces and selling some of their businesses, as is being done in many countries with and without the encouragement of governments. This approach fully applied involves breaking up institutions into unique entities with their own shareholders and managements and arbitrarily capping their absolute size. We do not know enough to say how small is small, however, or which individual institutions could fail without adverse systemic consequences, in part because those consequences depend on circumstances.

Moreover, if one large institution is broken up into, say, 5 or 25 smaller institutions, one can ask if the system really would be better off. If each of the smaller institutions follows the same or very similar investment strategies, known as herding, and has similar risk management policies, they may all experience similar stresses and losses. The systemic effects of letting them all fail would be the same as the systemic effects of letting the one large institution fail. It is possible that institutions would not herd or that their smaller, reduced size would limit some scope for excessive risk taking, but that is a conjecture, not an established fact.

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