by Ron J. Feldman
The government's response to the 2007-08 financial turmoil, although justified, expanded the safety net normally reserved for large banks and exacerbated the existing too big to fail (TBTF) problem. A larger TBTF problem is costly, having the capability to sow the seeds of future financial crises, which means policymakers should begin now to develop a new approach to manage TBTF.
While safety net expansion has increased TBTF concerns, the essence of the problem and underlying cause of TBTF remain clear: Policymakers support large-bank creditors to contain or eliminate spillover effects, but the support creates an incentive for too much risk-taking in the future. Our approach is straightforward. If spillovers lead to government support, then policymakers who want to reduce creditors' expectations of such support should enact reforms that make spillovers less threatening. Reforms that fail to address this fundamental issue will not change policymaker behavior and will not convince creditors that they face real risk of loss.
So what should policymakers do to address concerns over spillovers? The Federal Reserve Bank of Minneapolis recommends an approach labeled systemic focused supervision (SFS), which focuses supervision and regulation efforts on spillover reduction, and which consists of three pillars:
In particular, SFS uses the information-gathering and analytical skills of supervisors to better understand how one firm's impairment might spread to other firms or markets; it relies on the enforcement capabilities of regulation (combined with market information) to close firms before they incur losses that could bring down their peers; and it extends central bank communication techniques to financial-stability-related efforts.
The following links include recent essays and speeches on this subject produced at the Bank for more than 10 years, including the Bank's 2007 Annual Report. In addition, readers may be interested in reading the book Too Big to Fail: The Hazards of Bank Bailouts, by Gary Stern (President) and Ron Feldman (Senior Vice President), published by Brookings Press in 2004. Read an excerpt from the book.
Information on Too Big To Fail: The Hazards of Bank Bailouts is available from Brookings Institution Press.