Ending 'Too Big to Fail' Is Going to Be Hard Work

Ending the treatment of certain firms as “too big to fail” requires addressing two mutually reinforcing issues: first, the expectation that creditors of some financial institutions are protected by implicit government support, should those institutions become troubled; and second, the obligation many policymakers feel to support certain institutions to protect creditors from losses. The current system encourages fragility, which induces interventions. The Dodd-Frank Act attempts to deal with “too big to fail” through the establishment of the Federal Deposit Insurance Corp.’s Orderly Liquidation Authority, but there remains considerable regulatory discretion in how a firm is wound down — discretion that could encourage creditors to believe they may continue to receive protection from losses. A more promising alternative is to require firms to establish “living wills” that would facilitate rapid and orderly resolution and would not expose taxpayers to extraordinary financial support. Credible living wills might lead to less complex relationships among affiliates of financial firms and perhaps even smaller institutions. But ending “too big to fail” protection is vital. According to Richmond Fed researchers, roughly 57 percent of all financial sector liabilities were either explicitly or implicitly protected at the end of 2011. Such a system is not sustainable.