“Too big to fail” (or “TBTF”) is one of the most widely used phrases in the present-day vocabulary of finance. In both high-level policy discussions and popular press, it stands for the core dysfunction of the modern financial system: the recurrent pattern of government bailouts of large, systemically important financial institutions. The financial crisis of 2008 made TBTF a household term, while also leading to the creation of even fewer and bigger financial institutions. To this day, TBTF remains at the center of the policy debate on financial markets and regulatory reform. Yet, the analytical content of this term remains remarkably unclear. In many ways, it still functions as the discursive equivalent of the common “you know it when you see it” philosophy.
In a forthcoming article, I attempt to offer a novel framework for understanding the complex of closely related but conceptually distinct regulatory and policy challenges the TBTF label actually denotes. I start by identifying and defining a fundamental paradox at the heart of the TBTF problem: TBTF is an entity-centric, micro-level metaphor for a cluster of interrelated systemic, macro-level problems. I further argue that this largely unacknowledged inherent tension between the micro and the macro, the entity and the system, renders TBTF a uniquely complex phenomenon and explains the seemingly intractable and persistent nature of the TBTF problem.
To operationalize this insight, the article deconstructs the TBTF metaphor into its two basic components: (1) what I call the “F” factor focused on the “failure” of individual financial firms; and (2) what I call the “B” factor focused on their “bigness” (i.e., relative size and structural significance). Isolating and examining these conceptually distinct components helps to explain why the potential for failure (and bailout) of individual firms – or the “F” factor – continues to be the principal focus of the ongoing TBTF policy debate, while the more explicitly structural, relational issues associated with financial firms’ “bigness” – or the “B” factor – remain largely in the background of that debate.
Historically, the phrase “too big to fail” emerged directly in response to, and in the context of, government efforts to rescue large private companies from bankruptcy. It is, therefore, hardly surprising that public discussions on the TBTF problem continue to revolve primarily around the ever-present possibility of government bailouts of failing financial institutions. In a fundamental sense, bailouts violate the ideologically enshrined public-private boundary in a modern capitalist economy and expose the porous and negotiated nature of that boundary. Bailouts involve publicly funded assistance to privately owned firms and thus inevitably trigger negative reactions across the political spectrum, especially during systemic crises. Accordingly, placing the undesirable macro-level effects of certain financial firms’ failure – or the “F” factor – at the core of the TBTF problem gives the debate a degree of conceptual and normative clarity that is critical from the perspective of devising and implementing specific policy responses.
The “B” factor, on the other hand, is much more ambiguous and open to competing interpretations. It refers not only to individual firms’ balance-sheet size but also to their “systemic significance,” (PDF: 244 KB) as measured by their interconnectedness, organizational complexity, product substitutability, and other similarly relational and fluid metrics. Isolating, measuring, and balancing these attributes is notoriously difficult and deeply contestable. The “B” factor thus lacks the normative clarity and rhetorical appeal of the “F” factor. This, in turn, explains why the TBTF debate remains focused primarily on the failure of individual financial firms rather than on their “bigness.”
Applying this two-factor framework to the post-crisis legislative and regulatory efforts to solve the TBTF problem in the financial sector reveals critical gaps in that process. As my forthcoming article shows, it isn’t just public discussions that revolve around the “F” factor: the overall strategy of post-crisis regulatory reform in this area has been consistently favoring the inherently micro-level “F” factor solutions over the more explicitly macro-level “B” factor ones. The former category includes strengthened bank capital and liquidity regulation, regular stress testing, “living wills” requirements, and the “orderly liquidation authority” regime. These measures constitute the key tools and levers of post-crisis macroprudential regulation. The highly controversial Volcker Rule, which limits insured banking entities’ proprietary trading capabilities, is the single most visible example of a currently implemented “B” factor solution. Beyond that, there is little appetite among the policymakers for imposing direct size or activity limitations even on the largest financial conglomerates. As the article shows, this reluctance to adopt structural reforms and the continuing emphasis on minimizing individual firms’ failure, in turn, help to explain the recurrence and severity of certain system-wide problems typically framed as the “unintended consequences” of financial regulation.
On this basis, the article outlines a few potential ways of rebalancing and expanding the TBTF policy toolkit, in order to target the relevant systemic dynamics more directly and assertively. These suggested measures range from the more proactive use of the familiar structural tools to the more novel modes of direct public participation in the operation of financial markets. Of course, implementing such deliberately system-targeting policies would require a fundamental qualitative shift in the way we think and talk about the financial system and its dysfunctions. This is not easy to do in practice. Yet, as I argue in the article, this deep attitudinal shift is the necessary first step toward finally achieving the lofty and persistently elusive goal of eliminating the TBTF phenomenon in finance.
Saule Omarova is a Professor of Law at Cornell Law School.
The above post is adapted from The ‘Too Big To Fail’ Problem (Saule T. Omarova; forthcoming 2019).
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