In the ideal world of economics, firms that take excessive risks go bankrupt, their competitors pick up the pieces and the economy marches on. Some call it "creative destruction." In the real world, certain financial institutions are so big and so interconnected that their collapse - no matter how richly deserved - threatens plain old destructive destruction. Government steps in, with taxpayer money, to prevent that.
The problem of "too big to fail" is at the heart of the current crisis, in a double sense. Despite government disavowals, the perception that the feds would bail out the likes of Bear Stearns or Fannie Mae permitted such firms to pile on risk without corresponding discipline from the market, thus hastening the ultimate collapse. And, once the downward spiral began, the Federal Reserve and Treasury, armed with uncertain legal authority, faced a series of ad hoc choices as to which institutions to bail out and how.
Draft legislation before the House Financial Services Committee, which the Obama administration supports, rests on the assumption that too-big-to-fail is not only a reality but a reality that should be acknowledged in law. It seeks, in effect, to shape market perceptions by designating certain institutions, including not only banks but major players in the "shadow banking" sector, as eligible for government-led winding-down in a crisis.
In return for that security, they would face tighter regulation and higher capital requirements, so as to make it less likely that they would ever need a bailout in the first place. The measure prescribes procedures for any "resolutions" that might prove unavoidable. Among the bill's novel concepts is making financial institutions pay into a common fund to resolve failed giants, so taxpayers don't have to.
Yet while it is logical to admit the reality of too-big-to-fail, it is difficult to create the right mix of preventive incentives. For example: Should institutions pay into the insurance fund before one of them collapses, or after?
Sheila Bair, chairman of the Federal Deposit Insurance Corp., favors the former, so the government won't have to squeeze Wall Street in the middle of a panic. Treasury Secretary Timothy Geithner favors the latter, so that institutions have an incentive to stay out of trouble in the first place. The Federal Reserve would take a bigger role in policing strategic institutions. This will make good use of the Fed's expertise and independence - unless it erodes both by exposing the central bank to constant lobbying.
Policymakers seem to have rejected former Fed chairman Paul Volcker's proposal to separate commercial banks, which would enjoy a measure of government guarantee in return for heavy regulation of their risk-taking, from investment banks and other non-bank financial players, which would be free to trade in risky assets on the understanding that there would be no bailout. In theory, this would clarify market signals, thus restoring market discipline.
Yet even under this plan the market might try to call the government's bluff. When it comes to solving the dilemma of too-big-to-fail, no one has a certain template - and all participants in the coming debate would be well-advised to remember that.