Committing to Financial Stability

“Too big to fail” results from two mutually reinforcing conditions: Investors feel protected by an implicit commitment of government support, and policymakers feel compelled to provide that support to avoid a disruptive adjustment of expectations. The origins of too big to fail can be traced back to the introduction of federal deposit insurance in 1933. The problem was exacerbated by a series of rescues by the Federal Reserve and the FDIC that began in the 1970s, and by policymakers' actions during the financial crisis of 2007–08. The Orderly Liquidation Authority created by the Dodd-Frank Act retains many of the flaws of ad-hoc pre-crisis practices and does little to improve creditors’ incentives to monitor risk-taking. A better strategy for ending too big to fail is the provision in the Dodd-Frank Act requiring large financial firms to prepare “living wills” detailing how they could be resolved under the Bankruptcy Code. Resolution planning is difficult work, but living wills must be credible in order for policymakers to commit to using them rather than relying on government backstops.