Loading ...Have we ended the era of institutions that are deemed “too big to fail”?
Unfortunately, I do not believe that we have. Despite myriad legislative and regulatory responses to the crisis, such as the Dodd-Frank Act of 2010, we have so far failed to address a fundamental problem at the heart of the financial crisis of 2007-08.
That problem is that market participants have come to expect government support when large financial institutions become distressed.
Strengthening regulatory restraints on risk-taking and improving the quantity and quality of capital positions are important measures to reduce the likelihood of distress. By themselves, though, they are likely to be insufficient. If we want to prevent similar financial crises in the future, and truly solve the problem of institutions that seem too big to fail, we must realign the incentives of financial market participants. That requires a credible commitment on the part of policymakers and regulators to end their reliance on government backstops.
Let’s be clear about the problem we are trying to solve. The perception that some institutions are too big to fail results from two mutually reinforcing conditions. First, creditors of some financial institutions feel protected by an implicit government commitment of support should the institution become financially troubled. Second, policymakers often feel compelled to provide support … since withholding support could provoke a sudden, turbulent readjustment of investor beliefs regarding support for other similarly situated firms. Read more