While the bills that have been passed in the Senate Banking Committee and on the House floor express the desire to see losses imposed on failing firms' creditors, they provide the government with wide-ranging discretion to designate financial firms as "systemically important" and use public funds in their resolution. But the resulting ambiguity about rescue policy is likely to just perpetuate the forces that brought us "too big to fail" to begin with. Improved regulations will contain the risks that brought us the last crisis, but new risk-taking arrangements inevitably will arise that by-pass existing regulatory restraints. If authorities allow creditor losses at one failing firm, then creditors are likely to pull away from other similar firms, fearing that authorities will forgo supporting them as well. Authorities will feel compelled to resolve uncertainty about implicit safety net support by expanding implied commitments. Subsequent regulations will rein in the new arrangements, the danger of which will by then be fully appreciated. But this just sets the stage for another cycle of by-pass, crisis, rescue and regulation.

A discretionary safety net, with no set boundaries, only feeds this cycle by giving market participants reason to believe that new, complex arrangements ultimately will be protected. It requires an ever-growing reach of financial regulation, and undermines the market discipline that helps align financial risk-taking with broader societal interests.

[T]here should be a clear expectation that the shareholders and creditors of the failing firm will bear losses to the fullest extent consistent with preserving financial stability. To personalize things for this audience, we must ensure that if you have invested money in a large financial firm that runs aground, you will suffer losses. Shareholders of the firm ultimately are responsible for the organization's management (or mismanagement) and are supposed to be in a first-loss position upon failure of the firm. Shareholders, therefore, should pay the price for the firm's failure and should not benefit from a government-managed resolution process.

It is unconscionable that the fate of the world economy should be so closely tied to the fortunes of a relatively small number of giant financial firms. If we achieve nothing else in the wake of the crisis, we must ensure that we never again face such a situation.

[I]t is the largest financial firms that have an implicit, recently made explicit, guarantee that taxpayer dollars will be used to protect them from failure, regardless of what risks they assume.  It is only now that we are discussing legislation to address the issue of a special class of the largest firms that we have deemed too-big-to-fail.  This is the one item that must be addressed if we are to have any real competitive equity among all financial institutions.  What is proposed may need to be strengthened, but it is a start.

The dangers posed by TBTF banks are too great. To be sure, having a clearly articulated “resolution regime” would represent steps forward, though I fear they might provide false comfort in that a special resolution treatment for large firms might be viewed favorably by creditors, continuing the government-sponsored advantage bestowed upon them. Given the danger these institutions pose to spreading debilitating viruses throughout the financial world, my preference is for a more prophylactic approach: an international accord to break up these institutions into ones of more manageable size—more manageable for both the executives of these institutions and their regulatory supervisors. I align myself closer to Paul Volcker in this argument and would say that if we have to do this unilaterally, we should. I know that will hardly endear me to an audience in New York, but that’s how I see it. 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 it surely cannot be done in the middle of a crisis.

To solve the too-big-to fail problem, we need to do two things. First, we need to develop a truly robust resolution mechanism that allows for the orderly wind-down of a failing institution and that limits the contagion to the broader financial system. This will require not only domestic legislation, but also intensive work internationally to address a range of legal issues involved in winding down a major global firm.

Second, we need to reduce the likelihood that systemically important institutions will come close to failure in the first place. This can be done by mandating higher capital requirements, improving the risk capture of those requirements and by requiring greater liquidity buffers for such firms.

And the third thing we need is to really begin to listen to the Volcker Rule and to Paul Volcker and to begin to think about how you put detail around that and how you would implement over the future so that we don’t find ourselves dealing in an emergency overnight situation without clear guidance.

Government interventions during the past couple of years, however necessary, revealed a set of policy preferences. These expectations must be unlearned by market participants. Eradicating the too-big-to-fail problem should be the main policy goal.

If it cannot be achieved, the next-best regime may involve choosing a point between two competing models: regulating what financial institutions can do, and regulating how they do it (as Paul Tucker at the Bank of England set out). Clear rules – more focused on the what than the how – could free them to depart Washington’s lobbies and get back to business.

So what can we do about the “too big to fail” problem? It is clear that we must develop a truly robust resolution mechanism that allows for the orderly wind-down of a failing institution and that limits the contagion to the broader financial system. This will require not only legislative action domestically but intensive work internationally to address a range of legal issues involved in winding down a major global firm.

Well, I think that there is a question of how big is too big? I'ld like to see what we can do in terms of addressing the fail problem. But we have more capital, better liquidity, and have a way of resolving those institutions in a way that they can actually be allowed to fail, then I don’t think you necessarily have to break the banks up.  If we can’t succeed in that measure, then I think that Mr. Volcker’s alternative may be the way we’re going to have to go. That said, we have large multinational corporations that do business around the world. We need large banks to service those corporations to have a healthy economic environment.

[Regulators should] designate banks in advance that are systemically important... Preparation is really important. We have to define 'systemic' to get things started to deal with this issue [of too big to fail].

Consider this passage from Book III of Milton’s Paradise Lost, where God answers the question of why He created men and angels who could rebel against Him. Of man, He responds:

“… I made him just and right,
Sufficient to have stood, though free to fall.
Such I created all th’ ethereal Powers
And Spirits, both them who stood and them who failed;
Freely they stood who stood, and fell who fell. …”[1]

As is clear from this most celebrated work of literature, the issue of whether entities—be they mortal or divine—should be allowed to fail is one of the oldest philosophical quandaries.

Again, as the discussion of too-big-to-fail institutions has increased so (somewhat ironically) has the size of many of our largest global financial firms. Figure 1 shows the size of the three largest U.S. banks, relative to the size of U.S. GDP. As is clear from the figure, the largest institutions have over time become larger relative to the size of the economy. And not only have many of the largest U.S. banking institutions grown larger, but in some cases they have become more complex – as they acquired firms that offer investment banking services and, also, expanded the global reach of the acquiring firm.

Some additional potential regulatory devices are already under active consideration, both among U.S. bank supervisors and in international forums. These include proposals to create special charges on firms based on their systemic importance, to require contingent capital that would be available in periods of stress, and to counter pro-cyclical tendencies by establishing special capital buffers that would be built up in boom times and drawn down as conditions deteriorate. Each of these ideas has substantial appeal. A number of thoughtful proposals are being discussed, though each idea presents considerable challenges in the transition from good idea to fully elaborated regulatory mechanism.

Yet to gain traction are proposals for what might be termed structural measures--that is, steps that would directly affect the nature and organization of the financial services industry. But discussion of such concepts is clearly increasing.

One suggested approach is to reverse the 30-year trend that allowed progressively more financial activities within commercial banks and more affiliations with non-bank financial firms. The idea is presumably to insulate insured depository institutions from trading or other capital market activities that are thought riskier than traditional lending functions, although separating trading from hedging and other prudent practices associated directly with lending is not an altogether straightforward proposition.

In any case, this strategy would seem unlikely to limit the too-big-to-fail problem to a significant degree. For one thing, some very large institutions have in the past encountered serious difficulties through risky lending alone. Moreover, as shown by Bear Stearns and Lehman, firms without commercial banking operations can now also pose a too-big-to-fail threat. Still, imposition of higher capital and liquidity requirements for riskier trading and other capital market activities can, if well devised and implemented, achieve some of what proponents of this approach seem to have in mind.

The government-arranged and subsidized absorption of Bear Stearns into JPMorgan Chase draws attention to two additional features of the too-big-to-fail problem. First, no matter what its general economic policy principles, a government faced with the possibility of a cascading financial crisis that could bring down its national economy tends to err on the side of intervention. Second, once a government has obviously extended the reach of its safety net, moral hazard problems are compounded, as market actors may expect similarly situated firms to be rescued in the future. Both these observations underscore the importance of adopting robust policies in non-crisis times that will diminish the chances that, in some future period of financial distress, a government will believe it must intervene to prevent the failure of a large financial institution.