Too Much “Too Big to Fail”?

LONDON – Obviously, the global financial crisis of 2008-2009 was partly one of specific, systemically important banks and other financial institutions such as AIG. In response, there is an intense debate about the problems caused when such institutions are said to be “too big to fail.”

Politically, that debate focuses on the costs of bailouts and on tax schemes designed to “get our money back.” For economists, the debate focuses on the moral hazard created by ex ante expectations of a bailout, which reduce market discipline on excessive risk-taking – as well as on the unfair advantage that such implicit guarantees give to large players over their small-enough-to-fail competitors.

Numerous policy options to deal with this problem are now being debated. These include higher capital ratios for systemically important banks, stricter supervision, limits on trading activity, pre-designated resolution and recovery plans, and taxes aimed not at “getting our money back,” but at internalizing externalities – that is, making those at fault pay the social costs of their behavior – and creating better incentives.

I am convinced that finding answers to the too-big-to-fail problem is necessary – indeed, it is the central issue being considered by the Standing Committee of the Financial Stability Board, which I chair. But we must not confuse “necessary” with “sufficient”; there is a danger that an exclusive focus on institutions that are too big to fail could divert us from more fundamental issues.