'Too Big To Fail' Has Only One Solution

(MoneyWatch)  No financial firm should be too big to fail, said Federal Reserve Bank of New York chief William Dudley in a speech yesterday. But he's oddly silent on the logical consequence of that ethos -- making firms smaller:

Finally, it is critical that we ensure that no firm is too big to fail. This is about both fairness and having proper incentives in the financial system. Having some firms that are too big to fail creates moral hazard. These firms are able to obtain funding on more attractive terms because debt holders expect that the government will intervene rather than allow failure. In addition, too big to fail creates perverse incentives. In a too-big-to-fail regime, firms have an incentive to get large, not because it facilitates greater efficiency, but instead because the implicit government backstop enables the too-big-to-fail firm to achieve lower funding costs.

So far so good. And Dudley's proposed solutions to the problem are to create a government authority to wind down failing financial companies; raise bank capital requirements; improve regulators' ability to assess risk; and ensure that firms are sufficiently liquid.

Yet none of these, singly or in tandem, will take an inch off, say, JPMorgan Chase (JPM) or Goldman Sachs (GS). Absent a tighter cap on size (than that provided under the 1994 Riegle-Neal Act) -- perhaps as a percentage of national GDP -- prescriptions such as forcing financial companies to hold more money in reserve could actually make things worse. That's because banks would have an incentive to grow bigger in order to sustain profits while boosting their capital cushions. And liquidity is no cure for moral hazard.

Certain regulatory proclivities also ensure that risk will keep sprouting up. When times are good and financial firms are minting profits, bank supervisors hesitate to rein them in by, for instance, scaling back their use of derivatives. By the time the clouds roll in it's too late.

Meanwhile, getting better at identifying and managing risk, while necessary, is a moving target. Financial products shed their skins, shape-shift. So does risk. And so, consequently, does the very notion of too big to fail. It's a perception held in the minds of investors, government officials, bankers. And it exists in relation to the broader economy's ever-changing contours and dynamics. Controlling the toxic effects of that perception requires stronger medicine than resolution authority or enhanced risk management.

All of this to say that financial crisis -- like risk -- is a fact of life. Dudley's proposals, while constructive, don't do enough to make economic life less dangerous. The better option is to limit the damage when companies inevitably go astray, which requires shrinking them down to size. Banks must have room to grow large enough to perform their invaluable function. But they've got to be small enough to live with in peace.