"Too Big to Fail" is Not Going Away

The idea that any financial institution that's "too big to fail" (TBTF) shouldn't be allowed to exist has evidently gained significant support. What's discouraging is that people seem to think this is a sophisticated and workable strategy that we should actually pursue, mostly because people like former IMF official Simon Johnson say things like this:

I have yet to hear a single responsible official in any industrial country state what is obvious to most technocrats who are not currently officials: anything too big to fail is too big to exist.

This is the kind of thing people say at cocktail parties to make themselves sound smart without having to do any serious work. It's a preposterous idea.


There's a large literature on TBTF (see e.g., here, here, here, and here, but Johnson is clearly not familiar with any of it. I've followed this debate for quite a while, and I've never seen any expert in this field propose a policy of "too big to fail, too big to exist," so the idea that enacting such a policy is "obvious to most technocrats" is simply not credible. But as Dani Rodrik put it:

The [IMF] is staffed by a large number of smart economists, who lack much connection to (and appreciation for) the institutional realities of the countries on which they work. Their professional expertise is validated by the quality of their advanced degrees, rather than by their achievements in practical policymaking. This breeds arrogance and a sense of smug superiority over their counterparts -- policymakers who must balance multiple, complicated agendas.

Indeed.

Setting a limit on bank size is obviously not feasible. How do you think the FDIC resolves most failed banks? It uses Purchase and Assumption (P&A) transactions, in which another bank assumes certain liabilities of the failed bank in exchange for some or all of the failed bank's assets. The only reason the WaMu failure went so smoothly because JP Morgan agreed to steal buy WaMu through a P&A. Say the limit on bank size is set at $100 billion in assets. If a bank with $99 billion in assets failed, the FDIC wouldn't be able to use almost any form of P&A--including a Whole Bank P&A, which is the the most common resolution method--because the acquiring bank would be over the $100 billion limit after the acquisition. The fact that there are larger banks that can gobble up failed small banks through P&As is one of the biggest reasons the FDIC has been so successful in resolving failed banks.

In any event, it's clear that the people pushing the "too big to fail, too big to exist" policy fundamentally misunderstand the nature of the TBTF problem. The issue isn't the size of a financial institution per se, but rather its systematic importance. As Alan Greenspan famously framed it:

[T]he issue is an organization that is very large is not too big to fail, it may be too big to allow to implode quickly.

The reason this distinction is so important is that defining "too systematically important to fail" ex ante is simply not possible.

To be sure, systematically important financial institutions are usually quite large, but they don't have to be. Examples of large financial institutions that weren't systematically important include Drexel Burnham and BCCI, both of which failed without causing systemic damage.

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Economics of Contempt

"Economics of Contempt is a pseudonym of a structured finance lawyer in New York. He had taken a two year break from all finance-related law, but Lehman's failure put an end to that gravy train. He seems to spend most of his time in airports though. Especially LaGuardia. Which was fine until a plane leaving LaGuardia crash-landed in the Hudson. Now he freaks out every time he hits turbulence. When he's not fearing for his life or billing hours to financial institutions of questionable solvency, he likes to blog about financial markets, economic policy, or whatever else strikes his fancy."

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