Where do we stand with respect to fixing the problem of "too big to fail" (TBTF)? Are we making satisfactory progress, or it is time to think about further measures?

...While I agree that we have a long way to go, I believe that the way to get there is not by abandoning the current reform agenda, but rather by sticking to its broad contours and ratcheting up its forcefulness on a number of dimensions. In this spirit, two ideas merit consideration: (1) an increase in the slope of the capital-surcharge schedule that is applied to large complex firms, and (2) the imposition at the holding company level of a substantial senior debt requirement to facilitate resolution under Title II of Dodd-Frank. In parallel with the approach to capital surcharges, a senior debt requirement could also potentially be made a function of an institution's systemic footprint.

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Suppose instead we attack the problem by imposing capital requirements that are an increasing function of bank size. This price-based approach creates some incentive for all three banks to shrink, but lets them balance this incentive against the scale benefits that they realize by staying big. In this case, we would expect A, with its significant scale economies, to absorb the tax hit and choose to remain large, while B and C, with more modest scale economies, would be expected to shrink more radically. In other words, price-based regulation is more flexible, in that it leaves the size decision to bank managers, who can then base their decision on their own understanding of the synergies--or lack thereof--in their respective businesses.

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Suppose we do everything right with respect to capital regulation, and set up a system of capital surcharges that imposes a strong incentive to shrink on those institutions that don't create large synergies. How would the adjustment process actually play out? The first step would be for shareholders, seeing an inadequate return on capital, to sell their shares, driving the bank's stock price down. And the second step would be for management, seeking to restore shareholder value, to respond by selectively shedding assets.

But as decades of research in corporate finance have taught us, we shouldn't take the second step for granted. Numerous studies across a wide range of industries have documented how difficult it is for managers to voluntarily downsize their firms, even when the stock market is sending a clear signal that downsizing would be in the interests of outside shareholders. Often, change of this sort requires the application of some external force, be it from the market for corporate control, an activist investor, or a strong and independent board.11 As we move forward, we should keep these governance mechanisms in mind, and do what we can to ensure that they support the broader regulatory strategy.

I should note at the outset that solving the TBTF [Too Big to Fail] problem has two distinct aspects. First, and most obviously, one goal is to get to the point where all market participants understand with certainty that if a large SIFI [Systemically Important Financial Institution] were to fail, the losses would fall on its shareholders and creditors, and taxpayers would have no exposure. However, this is only a necessary condition for success, but not a sufficient one. A second aim is that the failure of a SIFI must not impose significant spillovers on the rest of the financial system, in the form of contagion effects, fire sales, widespread credit crunches, and the like. Clearly, these two goals are closely related. If policy does a better job of mitigating spillovers, it becomes more credible to claim that a SIFI will be allowed to fail without government bailout.

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Still, we are quite a way from having fully solved the policy problems associated with SIFIs. For one thing, the market still appears to attach some probability to the government bailing out the creditors of a SIFI; this can be seen in the ratings uplift granted to large banks based on the ratings agencies' assessment of the probability of government support. While this uplift seems to have shrunk to some degree since the passage of Dodd-Frank, it is still significant. All else equal, this uplift confers a funding subsidy to the largest financial firms.

Moreover, as I noted earlier, even if bailouts were commonly understood to be a zero-probability event, the problem of spillovers remains. It is one thing to believe that a SIFI will be allowed to fail without government support; it is another to believe that such failure will not inflict significant damage on other parts of the financial system. In the presence of such externalities, financial firms may still have excessive private incentives to remain big, complicated, and interconnected, because they reap any benefits--for example, in terms of economies of scale and scope--but don't bear all the social costs.

How can we do better? Some have argued that the current policy path is not working, and that we need to take a fundamentally different approach. Such an alternative approach might include, for example, outright caps on the size of individual banks, or a return to Glass-Steagall-type activity limits.

My own view is somewhat different. While I agree that we have a long way to go, I believe that the way to get there is not by abandoning the current reform agenda, but rather by sticking to its broad contours and ratcheting up its forcefulness on a number of dimensions. In this spirit, two ideas merit consideration: (1) an increase in the slope of the capital-surcharge schedule that is applied to large complex firms, and (2) the imposition at the holding company level of a substantial senior debt requirement to facilitate resolution under Title II of Dodd-Frank. In parallel with the approach to capital surcharges, a senior debt requirement could also potentially be made a function of an institution's systemic footprint.

Let me briefly mention another piece of the puzzle that I think is sometimes overlooked, but strikes me as having the potential to play an important complementary role in efforts to address the TBTF problem--namely, corporate governance. Suppose we do everything right with respect to capital regulation, and set up a system of capital surcharges that imposes a strong incentive to shrink on those institutions that don't create large synergies. How would the adjustment process actually play out? The first step would be for shareholders, seeing an inadequate return on capital, to sell their shares, driving the bank's stock price down. And the second step would be for management, seeking to restore shareholder value, to respond by selectively shedding assets.

But as decades of research in corporate finance have taught us, we shouldn't take the second step for granted. Numerous studies across a wide range of industries have documented how difficult it is for managers to voluntarily downsize their firms, even when the stock market is sending a clear signal that downsizing would be in the interests of outside shareholders. Often, change of this sort requires the application of some external force, be it from the market for corporate control, an activist investor, or a strong and independent board. As we move forward, we should keep these governance mechanisms in mind, and do what we can to ensure that they support the broader regulatory strategy.

The living wills program will require a great deal of hard work and detailed analysis. But I see no other way to reliably identify exactly what changes are needed in the structure and operations of financial institutions to end "too big to fail." I see no other way to achieve a situation in which policymakers consistently prefer unassisted bankruptcy to incentive-corroding intervention and investors are convinced that unassisted bankruptcy is the norm.

It is clear that the TBTF problem is small if living wills work so well that there is little or no likelihood of a distressed financial institution ever receiving support. But I would suggest too that the TBTF problem is also small if creditors perceive that, because of either economic conditions or capital requirements, there is little likelihood of important financial institutions becoming distressed. To use an analogy, some observers have expressed concern about emergency federal flood assistance creating a moral hazard problem. But, even if the government stands ready to provide full assistance to all in the event of a flood, I would expect the impact of the relevant moral hazard problem to be low for a house in the 10,000 year flood zone.

To the extent that a growing systemic footprint increases perceptions of at least some residual too-big-to-fail quality in such a firm, notwithstanding the panoply of measures in Dodd-Frank and our regulations, there may be funding advantages for the firm, which reinforces the impulse to grow. There is, then, a case to be made for specifying an upper bound.

In these circumstances, however, with the potentially important consequences of such an upper bound and of the need to balance different interests and social goals, it would be most appropriate for Congress to legislate on the subject. If it chooses to do so, there would be merit in its adopting a simpler policy instrument, rather than relying on indirect, incomplete policy measures such as administrative calculation of potentially complex financial stability footprints. The idea along these lines that seems to have the most promise would limit the non-deposit liabilities of financial firms to a specified percentage of U.S. gross domestic product, as calculated on a lagged, averaged basis...

Of course, the difficult question would be the applicable percentage of GDP. The answer would depend on a judgment as to how much of an impact the economy could absorb. It would also entail a judgment as to how large and complex a firm needs to be in order to achieve significant economies of scale and scope that carry social benefit... And depending on how Congress answered all these questions, there could well be need for defining transition periods and compliance margins. Even good answers to all these questions would produce a policy instrument that could seem excessively blunt to some. But this is a debate well worth having.

“You can reach a size where risk management becomes an exercise,” Fisher said today in response to audience questions following a speech to the Texas Bankers Association meeting in Fort Worth. “At what point do you reach a size you don’t know what is going on beneath you?”

“That is not the American form of capitalism,” Fisher said. “We are calling for significant downsizing of those institutions. We don’t feel the Dodd-Frank Act is the answer to the problem.”

“We pray for the big risk management teams in those big New York banks,” the Dallas Fed chief said.

“The most critical issue in addressing TBTF concerns is having policy makers with the resolve to follow through,” George said a speech today in New York. The U.S. must “correct the misaligned incentives and the improper expansion of federal safety net protections that encouraged and enabled institutions to take excessive risks.”

To achieve those goals, George said that regulators must not “view stress tests, other forms of quantitative analysis and models used by macroprudential supervisors as being a substitute or replacement for examiners and onsite supervision.”

“The power of the five largest banks is too concentrated,” he said. "The banks have become larger since the 2008 financial crisis and are now ‘too bigger to fail.’”

“I believe that too-big-to-fail banks are too-dangerous- to-permit,” Fisher said in the text of remarks given in New York today. “Downsizing the behemoths over time into institutions that can be prudently managed and regulated across borders is the appropriate policy response. Then, creative destruction can work its wonders in the financial sector, just as it does elsewhere in our economy.”

Strong capital and liquidity standards are central to an effective financial regulatory system. Well-crafted capital standards provide a buffer against loss from any activities of a bank, while good liquidity standards help provide assurance that a firm will have breathing space during a period of financial stress, whether idiosyncratic or systemic. But we cannot rely solely on these standards, important as they are, to provide a stable financial system. A necessary supplement is a strong resolution mechanism for systemically important firms, both to counter too-big-to-fail perceptions and to contain the harm to the financial system that would be caused by the failure of one of these firms.

However, three years after the failure of Lehmann Brothers, there remain significant impediments to avoiding the need for government intervention to protect large financial intermediaries.  Everyone knows that some large European financial institutions have of late encountered problems. So it is critical that we focus on strengthening the financial architecture, so that the struggles of one institution or a group of them no longer poses risks to the broader global economy. 

Hoenig spoke after international regulators forged an agreement over the weekend that requires the world’s largest banks to hold extra capital. The requirement is aimed at strengthening the biggest banks’ financial cushions to prevent another financial crisis.

Responding to an audience question, Hoenig said the surcharge may not reduce risks to the broader financial system, compared with his recommendations.

“I don’t have any faith in it at all,” he said. Discussing the Dodd-Frank law’s authority for the government to wind down a failing big firm without a bailout, Hoenig said, “I just can’t imagine it working.”

While there is much to criticize about Dodd–Frank, I cotton to those blunt statements on ending too big to fail. For, if after the myriad rules and regulations are written and implemented we have not eradicated too big to fail from our financial infrastructure, reform will have failed yet again.