Financial Regulation, Part One: Too Big to Fail

I promised not to torture you with boring policy drivel ("Questions," May 17, 2013). What follows is about financial regulatory policy, but I insist that it's neither boring nor drivel. Rather it's about a key and deep issue.

Let's get right to it. The massive elephant in the room is, and always has been, the free insurance, or the free put option, or the bailout entitlement -- call it whatever you want -- associated with financial institutions with the coveted status of "too big to fail" (TBTF). Rest assured, there's no better way to incent financial institutions to take massively undesirable risks, with disastrous macroeconomic consequences, than to give them "get of of jail free" cards.

Effete cognoscenti will yawn and note that this is hardly a new observation. They're right. Countless observers have been shouting for decades about the adverse incentives generated by TBTF. Gary Stern, former President of the Federal Reserve Bank of Minneapolis, and David Skeel, Professor of Law at the University of Pennsylvania, are two good examples. Take a look at their books here (Stern) and here (Skeel).

The problem is that the shouts have fallen on largely deaf legislative ears. Indeed Dodd-Frank effectively institutionalizes TBTF through a nasty cocktail of government "partnership" with financial institutions, combined with discretionary government distress-resolution procedures. A nightmare scenario if ever there was.

The same cognoscenti will now snap to attention and assert that Dodd-Frank recognizes TBTF's adverse incentives and thwarts them by increasing capital requirements and intensifying regulatory scrutiny. TBTF is no longer relevant, the story goes, because now we're regulating the large institutions so effectively that they'll never again be in danger of failing.

Do you really believe that? That is, is there any real reason to believe that this time the rain dance will work, that this time we've fixed the TBTF incentive problem, that this time is different?

To be continued...