The Future of Too Big Too Fail

As we emerge from the financial crisis, it is important to develop a framework for dealing with failing institutions. In particular, the nature of the doctrine of “too big to fail” must be addressed and re-examined. Recently, John Taylor and Larry White have spoken out about the need for a rule of law rather than a discretionary authority. Their comments and my thoughts are below the fold.

John Taylor’s recent testimony to Congress outlines his view on the path forward. Here is a brief excerpt:

Two main alternative proposals are currently under consideration. One has been put forth as part of the Administration’s financial reform proposals. It would establish a special resolution regime under which the Secretary of the Treasury, with the approval of the President and agreement of the regulatory authorities, could apply an expanded FDIC-like resolution process to any financial firm if its failure would have “serious adverse effects on the financial system or the economy.” The firm would be placed into conservatorship or receivership and t he government could provide the firm with loans, purchase its assets, or guarantee its liabilities.

The other proposal would have the failing financial firm go through a bankruptcy process designed specifically to deal with some of the financial firm’s assets and liabilities, which are an integral part of the financial system. The bankruptcy proposal in H.R 3310 is an example of such an approach. The conceptual idea is that the bankruptcy would permit important financial transactions to continue without significant disruption during bankruptcy.

In my view the expanded resolution regime has significant disadvantages in comparison with a bankruptcy process designed specifically for financial firms. First, the new resolution regime would essentially institutionalize the kinds of bailouts that have occurred in the recent crisis. Hence, rather than providing an alternative to policy of bailouts, it would permanently establish such a policy. Second, the expanded resolution authority would be operated with a considerable degree of discretion about when to start the intervention and about the priority to give different creditors. In contrast a bankruptcy process relies on an established rule of law rather than the discretion, and treats creditors in a known way that is understood by lenders and investors in advance. Compared to the resolution authority, bankruptcy is a more predictable process.

Larry White echoes much of this sentiment in a recent speech:

If everyone knows that the rule of law will be followed, such that nobody gets bailed out, the incentive for imprudence disappears along with the hook into taxpayers. I don’t mean that no financial firm will ever act imprudently, but that there won’t be a system-wide malincentive producing an epidemic of imprudence. If it is known that nobody is “too big to fail”, or too well connected to fail, then lenders will not let financial firms leverage up cheaply in the belief that they will be protected.

Each of these documents is worth your perusal.

Ultimately, the debate about the limits of the Fed’s abilities as lender of last resort and the doctrine of “too big to fail” boil down to the same principles that arose in the rules versus discretion debate for monetary policy. Discretion generates uncertainty in that the behavior of the actor cannot be predicted. As John Taylor has documented so well in his recent research, the erratic and inconsistent behavior of the Federal Reserve and the Treasury during the financial crisis can explain why the crisis (and corresponding economic performance) got so much worse in the months of September and October of last year.

Moving forward, policy needs to be guided not by the discretion of the central bank or the Treasury secretary, but rather by the rule of law. Orderly and predictable bankruptcy procedures for all firms and the elimination of the doctrine of “too big to fail” would go a long way toward making potential future financial crises less severe (and might prevent others altogether).

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