Systemic risks and the 'too-big-to-fail' problem'

Abstract

The financial crisis of 2007–9 resulted in state intervention in financial markets around the world, and the state became a major shareholder in many banks. While state bailouts were politically sensitive, policy-makers had little alternative but to supply funds to financial institutions that were viewed as ‘too big to fail’, or TBTF. In this paper, I review the history of, and the rationale for, the TBTF policy. I argue that, from a policy perspective, the most important costs of the TBTF problem are incurred ex ante, in the form of distorted incentives that arise as a consequence of distortions to the capital markets, and to the choice of banks’ scale and scope. I argue that it is impossible credibly to withdraw the TBTF policy, and, hence, that it should be managed so as to minimize the costs of these distortions. In this context, I discuss the role of policy in institutional design, in the restriction of bank scope, and in designing appropriate capital regulations.