Dealing with the too big to fail syndrome

One major problem with the banking system today is that many of the institutions are so large that it is difficult to imagine they can be allowed to fail by governments and regulators. That is why the collapse of Lehman was an epochal event in modern finance. Raghuraman Rajan argues that the right way to deal with the “too big to fail” syndrome is not to impose regulations that limit the size and activities of institutions. A better approach is to make it easier to close down these institutions. Systemically important financial institutions must be required to develop a plan that would enable them to be wound down in a matter of days. Such arrangements have been called “living wills”, “assisted euthanasia,” or “shelf bankruptcy” plans by different writers. Banks would need to track, and document, their exposures much more carefully and in a timely manner. The plan would require periodic stress testing by regulators and the support of enabling legislation— such as facilitating an orderly transfer of a troubled institution’s swap books to precommitted partners. The requirement to develop resolution plans would give institutions a strong incentive to reduce unnecessary complexity and improve management. Such an arrangement might also force management to be better prepared to deal with unexpected worst case scenarios.

As Calomiris mentions, living wills can create benefits for the financial system both prior to and during a crisis. Before a crisis, large complex banks would be more careful in managing their affairs. If the institutions are forced to plan their resolutions credibly in advance, and if this planning process is very costly, then they may appropriately decide to be less complex and smaller. After a crisis, because of the element of planning, changes in the control over distressed banks would occur with minimal disruption to other financial firms.