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Dealing with "Too Big to Fail"

Given the recent change in policy in Washington with the so called “Volcker Rule,” and the renewed attention to the problems caused by financial firms that are “too big to fail,” I thought it might be appropriate to present some of my own suggestions here on the Yale SOM Community Blog. The following essay was originally written in September 2008.

Dealing with “Too Big to Fail”
By Shyam Sunder Can we hope that, in dealing with the current crisis in financial markets, the U.S. government has dodged a bullet without inadvertently lighting the fuse to fire a canon ball? Bear Stearns was judged to be “too big to fail” because the hard-to-predict network effects of such a failure would have been potentially devastating to the U.S., and possibly the global, economy. Therefore, the government arranged a takeover of Bear Stearns by JPMorgan Chase and greased it with taxpayer money and guarantees. Having absorbed Bear Stearns, JPMorgan has grown. If either of them were too big to fail to begin with, it does not take a genius to recognize that the consequences of letting the combined entity fail would be even less acceptable. The wizards who run and oversee our financial system first permitted creation and growth of private financial institutions which they knew could fail, but could not be allowed to. Then, at the verge of failure, they combined them into larger institutions subject to the same risk and logic, only at a larger scale. This is postponing the day of reckoning with compound interest. After a year of crisis, the world financial system is headed towards consolidation into giants such as Bank of America, JPMorgan Chase, nationalized Fannie Mae and Freddie Mac, Barclays, UBS, Wells Fargo, Santander, and HSBC, etc. What are the consequences of living with a financial system consisting largely of a score of privately owned firms which cannot be permitted to fail? In what sense will these firms and the economy be private and capitalistic if they walk away with their profits, and dump their liabilities on taxpayers? The problem can be controlled, if not ameliorated, by adding too big to fail as a criterion for denying creation of financial institutions through organic growth, mergers or acquisitions. The traditional rationale for intervening in the size of firms has been antitrust — to promote competition in product markets to protect economic efficiency. Government bailouts of giant financial institutions on grounds that the domino effects of their failure for the domestic and the global economy are simply unacceptable suggests another new criterion for reviewing proposed mergers and acquisitions: Will the proposed merger or acquisition create an entity which the government (U.S. Fed, U.S. Treasury, EU, or national governments in Europe) will feel compelled to save from failure due to its domino effects? If the answer to this question is yes, the proposal should be denied approval to reduce the chances that the government may have to intervene at some time in the future to save the larger combined firm. Include this provision for Federal Reserve and Treasury reviews of mergers and acquisitions proposals to certify that it will not result in an entity that is too big to fail. Since firms could also grow internally, Congress could require an annual certification from the Fed and Treasury that no firm in the financial sector (defined as banking, investment banking, insurance and brokerage) is too big to fail. Shyam Sunder is the James L. Frank Professor of Accounting, Economics, and Finance at the Yale School of Management.