[A]ctions that strive to protect our largest institutions from failure risk prolonging the crisis and increasing its cost.  Of particular concern to me is the fact that the financial support provided to firms considered "too big to fail" provides them with a competitive advantage over other firms and subsidies their growth and profit with taxpayer funds.

The bottom line of our analysis is that creditors of large, complex financial institutions expected protection if failure threatened. As a consequence, they had little incentive to be concerned about the condition and prospects of such institutions, leading to underpricing of risk-taking. With risk underpriced, large institutions took on excessive amounts of it, leading eventually to the precarious position of some of them. And policymakers, fearing massive, negative spillover effects to other institutions, financial markets more generally, and the economy itself, validated creditor expectations by providing protection.

I do not mean to imply that regulation should punish firms for being efficient and innovative. Instead, it should offset or remove any advantages to becoming systemically important in the first place, perhaps encouraging some institutions to shrink, become less opaque, or lower their risk profiles.

[M]arket discipline is not now a credible check on the risk-taking of these firms; indeed, a critical plank of current policy is to assure creditors of TBTF (too-big-to-fail) institutions that they will not bear losses. Given the magnitude of the crisis, I have supported the steps taken to stabilize the financial system by expanding the safety net, but I am also acutely sensitive to the moral-hazard costs of these steps and have no illusion that losses experienced by equity holders and management will somehow resurrect market discipline.

Developing appropriate resolution procedures for potentially systemic financial firms, including bank holding companies, is a complex and challenging task that will take some time to complete.  We can begin, however, by learning from other models, including the process currently in place under the Federal Deposit Insurance Act (FDIA) for dealing with failing insured depository institutions and the framework established for Fannie Mae and Freddie Mac under the Housing and Economic Recovery Act of 2008.  Both models allow a government agency to take control of a failing institution's operations and management, act as conservator or receiver for the institution, and establish a "bridge" institution to facilitate an orderly sale or liquidation of the firm.  The authority to "bridge" a failing institution through a receivership to a new entity reduces the potential for market disruption, limits the value-destruction impact of a failure, and--when accompanied by haircuts on creditors and shareholders--mitigates the adverse impact of government intervention on market discipline.

If systemic risks at large financial institutions are particularly protected by the safety net of government credit, then such institutions will have an extra incentive to acquire precisely those risks. This may be why the unexpectedly large exposures of large banking organizations to home-mortgage-related risks stemmed from their provision of backstop liquidity commitments to a wide array of off-balance-sheet securitization arrangements. Institutions that are viewed as too big to fail may have had a comparative advantage in supplying contingent liquidity that was most likely to be needed in the event of dire macroeconomic shocks because those are the circumstances most likely to elicit broad-scale government lending support.

Some banks are not only "too big to fail," Mr. Volcker said. Some are "too big to exist."

As reported by the Washington Times

Particularly pressing is the need to address the problem of financial institutions that are deemed "too big to fail"...  In the future, financial firms of any type whose failure would pose a systemic risk must accept especially close regulatory scrutiny of their risk-taking.  Also urgently needed in the United States is a new set of procedures for resolving failing nonbank institutions deemed systemically critical, analogous to the rules and powers that currently exist for resolving banks under the so-called systemic risk exception.

 The problems of moral hazard and the existence of institutions that are "too big to fail" must certainly be addressed, but the right way to do this is through regulatory changes, improvements in the financial infrastructure, and other measures that will prevent a situation like this from recurring. Going forward, reforming the system to enhance stability and to address the problem of "too big to fail" should be a top priority for lawmakers and regulators.

We have long recommended that policymakers evaluate policies to address TBTF against their ability to appropriately reduce the likelihood that government will provide support to nominally uninsured creditors of large financial institutions. I believe that policymakers provide such support in order to limit the fallout, or spillovers, that arise when a large financial institution gets into trouble. So effective TBTF policies are ones that allow policymakers to better manage the spillovers from the collapse or failure of a large financial firm.

...

I'm skeptical of claims that the Federal Reserve or anyone else should have foreseen the situation as it actually played out. I also strongly support the actions the Federal Reserve has taken in response to these events, even with the undesired side effect of intensifying the TBTF problem. A significant issue, though, is what reforms should policymakers introduce to address the magnified TBTF problem? One criterion is that we consider reforms that would have helped prepare policymakers for the financial fallout they have faced over the last year or so, and it is my conviction that several reforms I have previously articulated fit that bill.

In view of what we have seen at some large financial institutions and in some funding markets, the need to address TBTF through a framework which reduces spillovers is critical, and we propose systemic focused supervision as a constructive first step in this process...Given the headwinds associated with the financial shock, the economy appears likely to be restrained until these conditions improve, and that will take some time.

Our preference is to allow market forces to handle any required restructuring in the financial services industry. However, in some cases this is not possible when the risks to financial stability are too high.

Regardless of our intentions, we need to recognize that by taking these actions, we create expectations about future interventions and who will have access to central bank lending. These expectations, in turn, can create moral hazard by influencing firms' risk management incentives and the types of financial contracts they write, which may ultimately increase the probability and severity of future financial crises.

Going forward, just as we should avoid setting unrealistic expectations for monetary policy, we should also avoid encouraging unrealistic expectations about what the Fed can do to combat financial instability. As I have argued, in times of financial crisis, a central bank should act as the lender of last resort by lending freely at a penalty rate against good collateral. Yet, recent experience suggests we need to clarify what the Fed can and cannot be expected to do in today's complex financial environment.

The events of the past year underscore the importance of carefully assessing the current financial regulatory structure. Regulatory reforms should aim to lower the chances of financial crisis in the first place, for example, by setting capital and liquidity standards that encourage firms to appropriately manage risk. We should consider market structures, clearing mechanisms, and resolution procedures that will reduce the systemic fallout from failures of financial firms. Indeed, it would be desirable to be in an environment where no firm was too big, or too interconnected, to fail.

...

I believe that the central bank should clearly state objectives and set boundaries for its lending that it can credibly commit to follow. Clarifying the criteria on which the central bank will intervene in markets or extend its credit facilities is not only essential but critical.

I'd like to say I think we do have a serious too big to fail problem in this -- in this economy. It's much worse than we thought it was coming into this crisis, and as we go forward, we need to develop methodologies to reduce that too big to fail issue, and this is what happened.

From the Q&A session.

[F]or a market economy to work best, it must to the maximum extent possible find a balance between financial stability and a stable price environment and in doing so must be able to allow individual institutions to fail.  The "Too Big to Fail" issue will only grow in importance as the consolidation of the financial industry grows in both size and scope in future decades.

We have long had a list of specific reforms to address TBTF, but we have not prioritized those proposals. So of the many recommendations we made, where would we have policymakers start? We would begin the effort to manage TBTF with an approach we call systemic focused supervision (SFS).

I earlier described SFS in general as an effort to apply a focus on spillover reduction to supervision, regulation, and communication as well, but let me now detail its three pillars: they are stress testing; enhanced prompt corrective action (PCA); and stability-related communication.