The regulatory structure for [systematically important financial institutions] should discourage systemically consequential growth or mergers unless the benefits to society are clearly significant. There is little evidence that the size, complexity, and reach of some of today's SIFIs are necessary in order to realize achievable economies of scale and scope. Some firms may nonetheless believe there are such economies. For them, perhaps, the highest level of an additional SIFI capital charge may be worth absorbing.

Important as it is, moral hazard is not the only worry engendered by very large, highly interconnected firms in financial markets. Assuming that a government overcomes time-consistency problems and credibly binds itself not to rescue these institutions, their growth would presumably be somewhat circumscribed. But it is possible, perhaps likely, that some combination of scale and scope economies, oligopolistic tendencies, path dependence, and chance would nonetheless produce a financial system with a number of firms whose failure could bring about the very serious negative consequences for financial markets described by the domino and fire-sale effects.

There are those who believe we have made great strides with Dodd-Frank and if we implement it well, all will be fine. Some believe that that the industry is over-regulated, which may be true, but we should not confuse over-regulated with well-regulated. And some of us are certain that in spite of all that’s been done and debated, the soundness of the largest financial institutions and the systemic risks they continue to pose is no better. In my view, it is even worse than before the crisis. As well-intentioned as the Dodd-Frank Act may be, it will not improve outcomes.

Today, I am convinced that the existence of too big to fail financial institutions poses the greatest risk to the U.S. economy. The incentives for risk-taking have not changed post-crisis and the regulatory factors that helped create the crisis remain in place. We must make the largest institutions more manageable, more competitive, and more accountable. We must break up the largest banks, and could do so by expanding the Volcker Rule and significantly narrowing the scope of institutions that are now more powerful and more of a threat to our capitalistic system than prior to the crisis.

It is ironic that in the name of preserving free market capitalism in this country, we have undermined it so deeply.

The debate ought to be who is in the safety net and who is out, being clear about who is in, regulating them appropriately. And then letting the rest deal with risk on their own. I think the markets are capable of doing that. And I think that requires a clear commitment for us to stay out of the process of bailing out large institutions that are outside the safety net.

The crisis has only made the biggest banks even bigger. “They have enormous power,” Mr. Hoenig said. “Just look at their lobbying expenses. I use the word — and it’s a fairly flammable word — oligarchy. These things are huge and powerful, and that’s where the money is. This country through its history has abhorred concentration of financial power, and for good reason.”

Mr. Hoenig does not have a vote next year, and he must retire after he turns 65 in September. As for his future, Mr. Hoenig, a train enthusiast who reads biography and history in his spare time, is certain that he will not follow other Fed veterans who have gone to work on Wall Street. “I can tell you one thing,” he said. “I’ll never work for a too-big-to-fail bank.”

Instead of more regulation, we need better-designed regulation that recognizes incentives and tries to address moral hazard so that market discipline can work. Overly proscriptive regulation is counterproductive - it increases the incentives to evade it, which ultimately defeats it. Financial innovation spurred by the desire to evade regulation and relocating activities outside of regulation’s reach are not productive, but they are an expected outcome if regulations are not well designed. Market discipline is an essential part of our market-based economy, and regulation should be designed to enhance it, not thwart it.

This requires scaling back some of the safety net subsidies that have risen over the years and increasing capital requirements.

My own sense is that the new facility will not have the credibility needed to deter the perception of too big to fail until it is actually used successfully.

Despite the provisions of the Dodd-Frank Act to end too- big-to-fail, community banks will continue to face higher costs of capital and deposits until investors are convinced it has ended.

One of the persistent worries during this crisis has been that some of the largest financial institutions in the U.S. and Europe might be exposed to additional losses and that a type of financial contagion could occur should conditions worsen. I think this is a misreading of the events of the past two years. U.S. and European policymakers have essentially guaranteed the largest financial institutions. This has been the essence of the very controversial "too big to fail" policy. The policy has clear problems, including its inherent unfairness and the fact that economic incentives for institutions that are guaranteed can be badly distorted. But to argue that governments would now give up these guarantees in the face of a new shock that could threaten the global economy seems to me to be far-fetched.

[A] provision in the Senate Banking Committee bill would restrict the Federal Reserve's supervisory authority to about 50 of the largest financial firms with $50 billion or more in assets. This would undermine the effort to end too big to fail, since the markets will likely interpret this provision as signaling that these firms are unique and will not be allowed to fail.

Winston Churchill said that “in finance, everything that is agreeable is unsound and everything that is sound is disagreeable.” I think the disagreeable but sound thing to do regarding institutions that are TBTF is to dismantle them over time into institutions that can be prudently managed and regulated across borders. And this should be done before the next financial crisis, because we now know it surely cannot be done in the middle of a crisis.

While the size of a specific financial firm is an important factor, it is only one of several factors that should be considered. Other important factors that need to be considered are contagion, correlation, concentration, and context—what we at the Federal Reserve Bank of Cleveland refer to as “The Four C’s.”

Contagion can be thought of as the “too interconnected to fail” problem. If an institution is connected to many other institutions and firms—through loans, deposits, and insurance contracts, for example—all of those firms may collapse if the first firm fails.

Correlation can be thought of as the “too many to let fail” problem. Institutions may engage in the same risky behavior as many other institutions, and the failure of one institution may result in the closure of all those institutions engaged in that same practice.

Concentration can be thought of as the “too dominant to fail” problem. In these situations, an institution has a market concentration sufficiently large that its failure could materially disrupt or lock up the market.

Context can be thought of as the “too much attention to fail” problem. Because of market conditions and other conditions that exist at the time, the closure of a particular institution may cause panic and result in the impairment of other firms.

Thinking about systemic importance in the context of these four factors results in a more reliable and comprehensive identification of firms that, in and of themselves, may be considered systemically important for reasons beyond just their size. Size is a necessary, but not sufficient, criterion upon which we should determine systemic importance.