How to Fix Too Big to Fail

Simon Johnson, the IMF economist turned Atlantic contributor turned prolific blog/wonk identity, has an interesting piece in the Times' Economix blog counting down three ways to fix "Too Big To Fail," the idea that major banks can grow so big that their collapse poses a mortal threat to the financial health of the economy. I'm going to count down with him, narrating my impressions as I go.

1. Do Nothing.

Huh? Johnson explains: "banks are likely to be more careful, at least for a while." This is exactly what we're seeing with Goldman Sachs. GS, the WSJ reported, is turning record profits recently with its fixed-income business, which is less risky than the illiquid derivatives it trafficked in before the collapse. In other words, it is behaving exactly the way Congress would like its high-flying investment banks to act.

But this comes with caveats. First, it's unlikely that Goldman will restrain itself away from riskier derivatives when the economy picks up and public outrage toward bankers mellows after the recession. Second, we're actually doing worse than nothing to kill "too big to fail": we're making the banks bigger! We've forced Bank of America to take on Merrill Lynch. We've helped JPMorgan take on Bear Stearns and Washington Mutual. Johnson reports that the top three banks now control more than 30 percent of all deposits, up from 20 percent a few years ago. Too big to fail is being replaced with way too big to fail.

2. Follow the Administration's Lead.
The administration's bank regulation plan, I've been learning, is something of a mixed bag that is comprehensive without being terribly ground-breaking. One of its main features would turn the Federal Reserve into what people like to call a "free safety" (in football, the free safety is often the hard-hitting defender in the secondary who can be used as an all-purpose tool to stop the run, cover a wide-receiver, or roam for interceptions), but Johnson is unconvinced that giving the Fed more independent power will fix the TBTF problem, especially since the independently powerful Fed was partly responsible for keeping interest rates low enough to allow a housing bubble to expand in the first place.

3. Go Big or Go Home.
The last option on Johnson's list is the hot porridge of the the Goldilocks trio: Compel the banks to downsize and use stress-tests to verify their institutional strength. Good luck with that! I don't begrudge Johnson the right to list this as an option. It is, after all, the prerogative of armchair generals to pull the debate closer to their side rather than decide it, and I think it's important to have people like Johnson trumpeting the TBTF anthem as long as they have lungs to do it. But it seems pretty clear to me (and, I'm sure, to Johnson) that we're all Goldilocks living in, at best, a middle-porridge world.

As I've written before, my concern is not that the second option, as presented by the administartion, will be ineffective at regulating the banks. My concern is that, in placing bank regulation on the docket after health care and climate change, we've scheduled bank regulation for exactly the time when most banks will be emerging from the recession. I agree with much of Johnson's Atlantic piece, which proposed that Wall Steet had developed a too-cuddly relationship with Washington in the last 20 years. In this world, the window of opportunity to regulate meaningfully is almost closed. I'm worried that before long, we'll have our noses pressed against the shut glass, watching a too-familiar scene unfold one more time.