The Path to Financial Stability

The problem of "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. Second, policymakers often feel compelled to provide support to certain financial institutions to insulate creditors from losses. This distorts the incentives of financial market participants to monitor and control risk. The origins of "too big to fail" can be traced back to the Emergency Banking Act of 1933 and the introduction of federal deposit insurance. Deposit insurance creates moral hazard, as demonstrated during the savings and loan crisis of the 1980s. 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. Variation across countries in the frequency of financial panics suggests that the policy environment can induce instability. Ex-ante constraints on risk-taking, such as the enhanced supervision of large financial firms in the Dodd-Frank Act, are important, but they may also increase the incentives for market participants to operate outside the regulated sector. A better approach than more regulation is to create a credible path to unassisted failure for large financial firms. Steps to achieve this include resolution planning, or "living wills"; adapting the bankruptcy code to the business of large financial firms; and identifying regulatory or legal impediments to private sector arrangements that would reduce instability.