Richmond Fed President Jeffrey M. Lacker Testifies on the Issue of 'Too Big to Fail.'

The problem known as “too big to fail” consists of two mutually-reinforcing expectations. The first is the belief among creditors of large financial institutions that these firms are protected by an implicit government guarantee against failure — making creditors less attentive to managing risks. The second is the belief among policymakers that certain financial firms are in fact “too big to fail” because their failure would be too disruptive of financial markets and economic activity. This belief leads policymakers to intervene in ways that protect creditors, strengthening creditors’ belief in an implicit guarantee. Thus, the interventions may well create greater instability by encouraging riskier market behaviors. The Dodd-Frank Act does not eliminate “too big to fail.” The Act’s Orderly Resolution Authority allows the discretionary use of public funds in the winding-down of distressed institutions, and gives the FDIC the ability to rescue their creditors. The existence of this discretion to use public funds, in turn, seems likely to perpetuate the belief in an implicit guarantee. The Act does offer a path toward a more stable financial system: the so-called “living will” process. These provisions require financial institutions to plan how they would be resolved under the Bankruptcy Code in an orderly manner and without public funds if they fall into distress. The resolution plans, which are subject to Federal Reserve and FDIC approval, will enable regulators to make a more credible commitment to withholding assistance to failing firms. Questions of whether to address “too big to fail” by making structural changes to large financial firms — such as limits on their size or their activities — should be addressed within the context of the process of developing resolution plans. In considering a proposed resolution plan, the Federal Reserve and the FDIC can order changes in the structure or operations of a firm to make it resolvable in bankruptcy without government assistance.