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February 25, 2014 at 06:17 AM
In one critical meeting on Sept. 16 (the day after Lehman Brothers Holdings Inc.’s bankruptcy), Tom Hoenig, then the president of the Federal Reserve Bank of Kansas City, stated the problem succinctly: “I think we tend to react ad hoc during the crisis, and we have no choice at this point. But as you look at the situation, we ought, instead of having a decade of denying too big to fail, to acknowledge it and have a receivership and intervention program.” Hoenig then warned: “We are in a world of too big to fail, and as things have become more concentrated in this episode, it will become even more so.”
See also: Bernanke says Fed increasing financial monitoring
Chairman Ben S. Bernanke agreedand noted, “We need a strong, well-defined, ex ante, clear regime. But we have the problem now that we don’t have such a regime, and we’re dealing on a daily basis with these very severe consequences. So it is a difficult problem.”
The 2010 Dodd-Frank Act created such a regime. Regulators, to their credit, have responded by implementing the law’s prohibition against using taxpayer funds to keep open failed institutions and by creating a transparent, clearly defined process to manage the failures of large, systemic financial companies.
Yet, even with meaningful progress, real doubts remain about the end of too big to fail. One reason is that regulators still have many substantive reforms left to deliver before the next failure. But another reason is that the public and the markets simply don’t believe the government can or will let such large companies fail when the time comes.
See also: Give us tougher financial reform, Americans say
On the substance, real risks remain. Although Dodd-Frank created a new orderly liquidation authority for potentially systemic institutions, that authority should be just a backstop. The real policy goal must be ensuring that these institutions can fail like all others — in a standard bankruptcy process, without the need for government support.
Dodd-Frank makes this clear in Section 165 where it requires regular “living will” filings designed to show that a financial company can credibly fail, without systemic disruptions, in bankruptcy. If a company can’t credibly make that showing, the law allows regulators to limit its activities or break it up.
There is no evidence that these large institutions have made credible progress toward restructuring themselves so they can fail like everyone else. They are still huge, complex, interconnected and entangled in cross-border derivatives. Their failure in bankruptcy would probably disrupt many of the essential services markets need to operate.
