Is Too Big to Fail Fixable?

Economist Paul Krugman wrote a piece Monday afternoon in which he appears to argue that it's impossible to fix the too big to fail problem, so we should just learn how to live with it. He says breaking up the banks won't help and the government swearing it won't bail any out firms doesn't work. On the surface, he's completely right. Neither of these tactics necessarily accomplishes a safer financial system. However, these options aren't entirely useless if refined. Krugman's alternative, which would cater to the systemically risky firms, is also useful to consider.

Breaking Up Firms

Krugman argues that lots of smaller firms failing isn't necessarily any better than if one big one fails. That's quite right: the economy would be approximately as much trouble if 100 financial insitutions with $20 billion balance sheets simultaneously failed as it would be if one with a $2 trillion balance sheet failed. He specifically notes the problem of bank runs here.

Yet, size does matter on some level. In particular, the second part of the so-called Volcker rule suggests that financial firms should have liability concentration limits. In other words, each institution would be limited to the amount of exposure it would have to certain types of products, firms and/or industries. While this doesn't directly call for smaller banks that would likely be the result. If lots of smaller banks develop diverse liabilities, then any one product, firm or sector won't bring it down. No single economic shock should cause a financial firm to incur losses so great that its capital base can't withstand them. (Of course, higher capital levels will also help here.)

Ending Bailouts

He's also right to say that the government can't simply say, "Okay, that's it: no more bailouts. Sorry guys!" We saw how poorly that strategy worked with Lehman. It triggered a financial crisis.

But just ending bailouts by deeming it so is different from developing a new regulatory framework which would anticipate and defuse scenarios where a bailout might be sought. Through various mechanisms like a non-bank resolution authority, failure plans, etc. the possibility of unavoidable of bailouts become more distant. Of course, Krugman is right to believe that it's impossible to say that the government will never have to bail out a firm no matter what. Unfortunately, the future is too unpredictable to make so strong a stance. But that doesn't mean a system shouldn't be developed which attempts to accomplish that end.

Krugman's Solution

Here's what he suggests:

What is true is that there are bailouts and then there are bailouts. What has to be protected in a crisis are bank deposits and things like bank deposits -- basically, bank-created money. Money market accounts and "repo" -- very short-term loans in which businesses often park their funds -- have to be protected to avoid 1930-31-type collapses. On the other hand, bank shareholders and long-term bondholders can be made to pay a price without collapsing the system.

Here, he appears to be arguing that financial institutions should be more utility-like, with some aspects of their business being protected. Whether he intends to be doing so or not, that sort of goes along with the argument that a non-bank resolution authority would have to insure certain kinds of transactions to avoid a crisis through resolving firms. It would have to worry about these "costs" just like the FDIC has to worry about the "cost" of backing up a bank's deposits. But if such a system is created, then it must apply to all financial institutions, not just the big ones. Otherwise, smaller ones will be left with a competitive disadvantage not having the same insurance benefit.

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Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation. More

Indiviglio has also written for Forbes. Prior to becoming a journalist, he spent several years working as an investment banker and a consultant.

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