Jay Ackroyd complained yesterday that my posts on financial regulation “are typical, they assume a policy objective of banks too big to fail.” I wouldn’t put it that way. Rather, I would say that despite the prominence of the term “too big to fail,” the bigness of banks really doesn’t have much to do with the fact that it’s dangerous to simply let banks fail. And you don’t need to take my word for it, ask Paul Krugman:
The point is that breaking up the big players, then saying that it’s OK to let banks fail because no one player is crucial to the system is not a solution.
Tim Fernholz has spelled this out at greater length. Or think about the FDIC — when a bank goes into the FDIC closure process, we say that it’s “failed” but we don’t submit it to the bankruptcy process and depositors all get their money. And this is extended to even the smallest of banks. The issue is that having banks go bankrupt is systemically disruptive no matter how big or small the banks are. What’s appealing about the way small, traditional banks are treated in the United States isn’t that they “fail” (i.e., go bankrupt) it’s that the FDIC process doesn’t lead to a bailout of bank managers or bank owners. But even if we cut the “shadow bank” players down to size, we’d still need to come up with a new regulatory/resolution framework.