Fans of campy science fiction films know all too well that outsized monsters can wreak havoc on an otherwise peaceful and orderly society.

But what B-movie writer could have conjured up this scary scenario—Too Big To Fail (TBTF) banks as the Blob that ate monetary policy and crippled the global economy? That's just about what we've seen in the financial crisis that began in 2007.

The wider we cast the net, the greater the incentives of market participants to evade regulatory constraints while still availing themselves of protection in situations of distress, leading to a continuing cycle of crisis and bail out. And I have a hard time believing that we really need a publicly funded financial-institution support system covering nearly half of the liabilities in our credit markets.

The recent financial crisis also revealed new dimensions of the TBTF problem. The systemic risk exception applies only to commercial banks. But recently there have been significant issues regarding the systemic implications from the failure of large nonbank financial firms. Significant problems in the U.S. have occurred surrounding investment banks, and similar concerns are being expressed about insurance companies and hedge funds. There are also issues regarding the relationships between banks and their parent holding companies.

Although we have a legal framework for dealing with failing institutions, we have learned that, in a crisis, the “systemic spillover” that can emerge from failures of our largest institutions and the threat to the broad economy require additional consideration. The most recent examples of this have led to the suspension of normal bankruptcy and bank resolution processes, thus institutionalizing the concept of too big to fail in our economic system.

If we have learned anything from the present crisis, it is that systemic risk was very much built into our financial system.  This situation was the outcome of a decades-long trend, during which traditional bank lending, trading, and other capital markets activities were increasingly integrated.

[A]t the onset of the current crisis, the financial regulatory system had accommodated the growth of capital market alternatives to traditional financing by relaxing some restrictions on bank activities and virtually all restrictions on affiliations between banks and non-bank financial firms. In place of the superseded restrictions were capital requirements focused on credit and market risk, along with a greater emphasis on supervision and risk management, especially at larger firms. These legal changes facilitated a wave of mergers and acquisitions that created a number of very large, highly complex financial holding companies centered on a large commercial bank. These were subject to prudential regulation. At the same time, there was a group of very large, significantly leveraged "free-standing" investment banks whose market practices were regulated by securities laws, but were not subject to prudential regulation.

The lesson I take from all this is that the existence of our financial safety net actually can amplify financial instability. A discretionary safety net in particular, creates incentives for “too-big-to-fail” institutions to pay little attention to and underprice some of the biggest risks we face – risks associated with events like the current turmoil in which large losses are widespread. Their tendency to underprice such risk exposures reduces market participants’ incentive to prepare against and prevent the liquidity disruptions that are financial crises, thus increasing the likelihood of crises.

Based on direct observation, I am not convinced that supervisors can consistently and effectively prevent excessive risk-taking by the large firms they oversee in a timely fashion, absent draconian measures that tend to throw out the good with the bad. For this reason, I am not confident that traditional S&R can reduce risk sufficiently such that it addresses the problems associated with TBTF status.⁶   While policymakers should improve S&R by incorporating the lessons learned over the last two years, it cannot be the bulwark in addressing TBTF.

I do see clear benefits in increasing the scope of bank-like resolution systems to entities such as bank holding companies....I have long argued that the resolution regime created by FDICIA would not, by itself, effectively limit after-the-fact protection for creditors of systemically important banks.

The key to addressing TBTF is to reduce substantially the negative spillover effects stemming from the failure of a systemically important financial institution.
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I see three general approaches to addressing concerns over spillovers and thus increasing market discipline (and reducing moral hazard). First, enact reforms that make policymakers more confident that they can impose losses on creditors without creating spillovers that would justify government protection. Second, reduce the losses that failing firms can impose on other firms or markets, which helps reduce spillovers. Third, alter payments systems to reduce their transmission of losses suffered by one firm to others.

[P]roposals which purport to address TBTF but which fail to correct incentives are unlikely to succeed. In particular, proposals to “shrink” the largest financial institutions or to rely on heightened regulation and supervision of and increased capital for such institutions do not address the fundamental problem and must therefore be viewed as unlikely to effectively curb TBTF.

[B]ankruptcy procedures are designed to provide a clear priority among creditors, but do not provide any special provisions for an insolvency that has broad systemic implications. In such situations, it is very possible that a preferable public policy would be to minimize systemic implications rather than follow the normal creditor priority set out in the bankruptcy code.

Some commentators have claimed that the housing boom and bust and the resulting turmoil illustrate fundamental flaws in modern financial markets and institutions. Before we jump to such conclusions, however, we need to evaluate the extent to which risk-taking incentives in financial markets have been distorted by actual and perceived government financial safety net protection. It strikes me as quite plausible that the major shortcomings of our system of housing finance are attributable primarily to the distorted behavior of institutions that are viewed as “too big to fail.”

[C]ritics suggest the failure of one of these institutions could be very disruptive and worsen the crisis, citing Lehman as an example. I am not at all advocating the approach taken with Lehman. Rather, I am arguing for a timely, managed and orderly resolution of large, insolvent institutions, with their basic functions continuing under new management.

In my view, the rush to respond has had negative consequences...Without a systematic plan for addressing the crisis, policy actions have been ad hoc, resulting in inequitable outcomes among firms, creditors and investors that have increased uncertainty and undermined confidence.  Nowhere is this more apparent than in the treatment of large, complex financial institutions that have been labeled as "systemically important" and "too big to fail."

I have outlined a resolution framework for how we deal with the large, systemically important institutions at the center of this crisis in the United States.  Boiled down to its simplest elements, the plan would require those firms seeking government assistance to put the taxpayer senior to all shareholders with the impact on managers and directors depending on the viability of the firm.  Nonviable institutions would be allowed to fail and be placed into a negotiated conservatorship or a bridge institution, with the bad assets liquidated while the remainder of the firm is operated under new management and reprivatized as soon as feasible.