I recently had the chance to do a Q&A with Elizabeth Warren, who chairs the Congressional Oversight Panel that monitors the government's bank rescues. While the whole thing is interesting, one point that particularly struck me was Warren's emphasis on making sure that regulators have the ability to dissolve large banks in the event of failure, as well as restraining them in advance:
Should the government step in and break up the biggest banks?
There are a lot of ways to regulate "too big to fail" financial institutions: break them up, regulate them more closely, tax them more aggressively, insure them, and so on. And I'm totally in favor of increased regulatory scrutiny of these banks. But those are all regulatory tools. Regulations, over time, fail. I want to see Congress focus more on a credible system for liquidating the banks that are considered too big to fail. The little guys aren't immortal; they pay for their mistakes. The big guys can't be immortal either. A free market cannot operate in a too-big-to-fail world.
I think her fundamental insight -- that regulations can be worked around, but liquidation remains the last source of market discipline -- is right on. As I've written before, the best way to eliminate the TBTF problem is by making sure the government doesn't have to choose between bailing out banks or letting them go into bankruptcies that could hurt the rest of the economy. Instead, make sure regulators can seize failing banks and quickly dissolve them. Both the House and Senate financial reform bills have provisions to do this that would be effective, but the details -- particularly, which agency will handle the liquidation (likely the FDIC) -- are still being determined.
-- Tim Fernholz