A great deal of the regulatory proposals flowing through Washington these days have to do with the problem of big financial firms having been too big to fail. On some level, that makes sense -- the bailouts were necessary because of this very issue. The logic goes: if these banks could have failed on their own, then the government wouldn't have had to step in. So the goal of creating an environment where even gigantic banks can fail appears to make sense. But would that have prevented the crisis?

Over at the Daily Dish, Andrew Sprung writes about a recent interview with the bailout's Congressional Oversight Panel chair Elizabeth Warren, conducted by Tim Fernholz. She addresses whether breaking up banks is the answer to the problem of being too big to fail:

Should the government step in and break up the biggest banks?

There are a lot of ways to regulate "too big to fail" financial institutions: break them up, regulate them more closely, tax them more aggressively, insure them, and so on. And I'm totally in favor of increased regulatory scrutiny of these banks. But those are all regulatory tools. Regulations, over time, fail. I want to see Congress focus more on a credible system for liquidating the banks that are considered too big to fail. The little guys aren't immortal; they pay for their mistakes. The big guys can't be immortal either. A free market cannot operate in a too-big-to-fail world.

Sprung says of this response:

In other words, it's more important to ensure that regulators can clean up failed banks, no matter how big, without systemic risk than it is to empower them to prevent large banks from failing. That's a conservative principle from the country's foremost financial consumer advocate. Warren wants to create the conditions that Alan Greenspan believed the market would impose unaided -- in which the real possibility of failure itself "regulates" the thinking of bank executives.

And he's right. Even though the creation of a non-bank resolution authority, demanding that banks submit failure plans and collecting an insurance premium to create a fund to cover costs resulting from their potential failures sounds an awful lot like big government regulation, such measures really seek to make the free market function better. If firms cannot fail, then capitalism doesn't work.

Since I am an advocate for free markets and competition, I've supported these regulatory goals. But a part of me also wonders whether too big to fail was really the problem. Granted, it was definitely a problem, as the government should never feel forced to engage in the messy business of bailouts. But was it the problem, i.e. would the crisis have been prevented, or would the world we know be better off, if these firms could have failed?

I have trouble answering this question in the affirmative. Let's say that all of the banks who received bailout money had been able to fail. Well, um, we'd have very, very few banks left -- and zero investment banks. Citi, Bank of America, Wells Fargo, Goldman Sachs, Morgan Stanley, JP Morgan and probably over a hundred more regional banks would be gone. So would some finance companies like Capital One and American Express. All of these institutions received bailout money.

Granted, a few of these firms might not have needed this money, or would have found a way to survive without it. But there's little doubt that a large number of these banks couldn't have coped without the bailout and would have failed. I don't think the world would have been better through this result.

But maybe it's the motivation that would have changed -- maybe the management at banks wouldn't have taken all of those ill-advised risks if they'd know that they could fail. This argument says that banks would never have gotten to the point they did if they'd known that they could fail. I think this theory also falls flat, however. I don't believe anyone -- least of all big bank executives -- thought that they were too big to fail in the sense the phrase came to be known.

There may have been a thought that some banks were just so big that they could never take stupid enough risks to end up failing. But that wasn't due to their interconnectedness; it was because investors thought the institutions were diverse enough that losses in one arm could never be large enough to result in the failure of the entire firm. That's a lot different from saying, if that unforeseen circumstance were to occur, then the government would step in to bail them out.

I honestly don't believe most bank executives thought they would be saved in such a scenario. As a result, I'm not entirely convinced that the threat of being able to fail would necessarily change their behavior. I want to believe that it would, but in my experience, bankers didn't think they were taking insane risks. They thought they were making smart bets but actually got the market very, very wrong.

If anyone out there can persuade me that the free market alone would have somehow made these bankers smarter, then please do so in the comments section. I don't think perverse incentives caused the market failure; it was just epic stupidity and getting things very, very wrong. That's why I find more true big government regulatory measures that I would normally rally against -- like higher capital requirements -- very difficult to argue with. I'm just not convinced bankers are smart enough to go back to business as usual without one day again threatening the nation's economy. They might believe they are, but recent history proves otherwise.

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