Too Big to Fail: “Systemic Importance” and Moral Hazard

The near meltdown of U.S. financial markets in the past year points up the vulnerability of markets to the insolvency of just one or two major institutions. The bankruptcy of Lehman Brothers and the near-death experience of American International Group (A.I.G.) brought the nation’s financial system perilously close to complete collapse.

Policymakers have two basic options for reforming the financial system so it is less vulnerable to the failure of just one or two major institutions. First, they can establish rules that shrink the maximum permitted size of U.S. banks and other financial entities. If Lehman Brothers and A.I.G. had been one-tenth as large, other market participants as well as public regulators would have viewed their insolvency with much less alarm. Government authorities and the courts could have unwound the companies’ businesses in an orderly way with less risk to the overall financial system and, equally importantly, without bailing out the firms’ shareholders and bondholders. Lehman Brothers’ and A.I.G. executives and the shareholders and bondholders who backed them would have experienced enormous losses, but the normal operations of U.S. capital markets could have continued with little interruption.

A second option is to increase the capital requirements of large institutions above those of smaller institutions and to subject the biggest institutions to more stringent rules and tighter regulatory scrutiny. We would still have major institutions that are too big to fail. Higher capital requirements would ensure, however, that an institution’s equity holders would absorb a greater percentage of the losses if a bailout were needed. (Reporters, pundits, and ordinary voters sometimes forget that a government bailout usually offers a lifeline to an institution’s debt holders and counter-parties but not to its shareholders.) Moreover, a regime of tougher regulatory oversight could mean that these institutions will be less likely to engage in behavior that places them at grave financial risk.

The more conservative of these two options is the second one, and it is the one the Obama Administration favors. Were it adopted regulatory authorities would not need to oversee a drastic downsizing of the nation’s biggest banks and other highly interconnected financial institutions.  Bank of America, Citibank, Wells Fargo, and JP Morgan Chase could retain their current size, but they would need to support their lending activity with a higher ratio of shareholder equity. They would also have to pay, directly and indirectly, for the additional cost of more intense federal oversight and tougher regulatory rules. The problem of moral hazard will remain, because bondholders and bank counterparties will continue to expect the government to bail out big institutions in the event of insolvency. Big banks’ shareholders would, however, be forced to absorb more of the losses that follow insolvency. If this approach is to work, regulatory oversight of the big institutions will have to be much stronger. It is important to emphasize, however, that moral hazard is a major problem in the current (unreformed) system. Increasing capital requirements and tightening  regulatory oversight of the biggest institutions may be the most practical ways to reduce the worst effects of the problem.

People who oppose tight government regulation or who are skeptical public regulators are up to their job should favor restrictions on financial institutions’ size and market share. The tradeoff is that large size may also give financial institutions advantages that flow from sheer economies of scale rather than outsize market power. If we limit the maximum size of banks and other financial institutions we are giving up the potential benefits of scale economies, not only for the banks themselves but also for their depositors and borrowers. 

Whether we adopt option #1 (unlikely) or option #2 (far more likely), it seems plain that the current regulatory regime cannot be left unchanged. The events of the past 18 months show that the risks of the status quo are too great.