Over the past two years, disruptive failures, shotgun marriages, and government bailouts of some household names in the financial industry have placed the age-old issue of “too big to fail” at the center of financial sector policy discussions. As well, the Lehman bankruptcy and government support for AIG extended the “too-big-to-fail” notion from banks to include nonbank financial institutions. And in some cases, the financial institutions in distress were not even particularly big; rather, they were too interconnected, and too important for the functioning of the global financial system, to be allowed to fail.

We need to think about how to deal with such “too-important-to-fail” institutions for at least three reason:

When institutions are provided with implicit (and explicit) public support, they are apt to take on riskier activities than they otherwise would, with the knowledge that the government will step in if those risks turn out badly. This is called moral hazard.

Well-run institutions are forced to compete with institutions that are implicitly guaranteed—or even directly financially supported—by the government. This makes for an unlevel playing field in the financial sector.

Government support absorbs valuable public resources, arguably at the expense of more equitable and productive public spending; it could also endanger the fiscal stability of a country.

Consequently, the G-20 leaders asked the Financial Stability Board to propose measures, by October 2010, to resolve the problems created by institutions that are “too important to fail.” In the interim, we are contributing to the exercise, providing input on the various proposals under consideration.

Prevention and resolution

In my view, there are essentially two complementary approaches to reducing the systemic risks posed by too-important-to-fail institutions: attempting to preventsystemic financial sector failures before they happen, and constructing a framework to resolve failed financial institutions in a way that minimizes disruption to the financial system once a failure occurs (i.e., resolution frameworks). 

There are many proposals in the area of prevention, including mandating higher capital, provisioning, and liquidity buffers; instituting various types of charges or taxes on institutions for their contribution to systemwide risks; using contingent capital instruments; improving risk management and accounting systems; splitting up institutions into smaller entities to mitigate systemic failures; and encouraging them to voluntarily desist from risky behavior that affects others.

In principle, economists are more comfortable attempting to influence the incentives faced by financial institutions rather than using administrative/legal or other means of splitting up various businesses. In practice, good incentive-based regulation is difficult to design and implement effectively, though it is still considered by many economists to be the “first-best” approach.

In the area of resolution frameworks, much could be done. Requiring financial firms to prepare a “living will” might be a good start. Living wills identify how institutions would unwind their activities in the case of their own demise. Also, a special resolution regime applied only to banks and certain types of regulated nonbank financial institutions would allow a failing financial firm, which is taken over by the government, to continue to function as an intermediary while it is dismantled or sold in part or whole to new owners.

At the IMF, we are investigating the pros and cons of the various proposals and coming up with some of our own. I hope this generates a productive discussion about this key issue, which has important implications for all taxpayers, consumers of financial services, and beneficiaries of a well-functioning financial system.

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