If it's too big to fail, it's too big

First, the very notion of “too big to fail” is dangerous. It suggests that there is an insurance policy that says, no matter how risky your behavior, we will make sure you stay in business. It encourages banks to get bigger (or more interconnected), and it subsidizes risky behavior.

Second, it leaves ambiguous the important issue of who gets protected in the event of insolvency–the equity holders, creditors, subordinated debt holders, etc. It seems fair to say that the solutions that have developed on the fly have done severe damage to the notion that there is a well-ordered capital structure that means something.

In recent weeks, two very independent voices have stepped forward to argue for the creation of mechanisms for taking over and shutting bank-holding companies and other large systemic institutions. Sheila Bair, chairman of the FDIC, has argued that the absence of an authority to shut failing systemic banks has cost the American taxpayers dearly because of the unprecedented government intervention in the financial sector.