I’m from Missouri; show me why big banks shouldn’t fail
It may be a coincidence, but both of the Show-Me State’s Federal Reserve Bank presidents have spoken in recent days about the too-big-to-fail problem. What’s more, James Bullard and Thomas Hoenig agree that we need to find a way for big banks to fail.
Hoenig, president of the Kansas City Fed, said yesterday that
a policy of “too big to fail” raises important issues. For example, it worsens the already significant problem of moral hazard in which investors do not monitor risk appropriately, assuming, correctly it would seem, that the government will bail them out of financial problems. Capitalism is a process of failure and renewal, and a policy that undermines the process makes the financial system and our economy less efficient.
Also, when some firms are treated as “too big to fail” they receive an implied subsidy and a competitive advantage over other firms.
Hoenig advocates putting troubled big banks into conservatorship, firing management and wiping out shareholders. The government would run the bank until it could be cleaned up sufficiently for a return to private ownership.
Bullard, president of the St. Louis Fed, discussed too-big-to-fail on Friday. In notes for a speech in Arkansas, he says:
These firms are often considered “too big to fail” because of the market disruption that might be caused. The correct phrase is “too big to fail … quickly.” No firm is literally too big to fail.
Bullard doesn’t endorse any particular mechanism for closing problem banks, but he says there should be one:
The most common response to the situation has been that we need more monitoring of large financial firms. It is unclear what monitoring by itself can accomplish. We need the resolution regime.
Bullard is echoing a point that Raghuram Rajan, a prominent finance professor at the University of Chicago, made last month in a speech at the St. Louis Fed. I summarized his views in an April 17 column:
Rajan also has done a lot of thinking about the too-big-to-fail problem. One popular solution is to somehow restrict banks’ size, but that’s the type of regulation that would almost certainly be lobbied out of existence during the next boom.
A better approach, Rajan says, is to make it easier for big banks to fail. He would require every bank to describe how it could be wound down over a weekend. The obstacles that make a bankruptcy frightening to contemplate now, including international ties and opaque derivatives deals, would all be dealt with ahead of time.
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David Nicklaus has covered St. Louis business for more than 25 years. His column appears three days a week on the Post-Dispatch business page. 
Excellent post. When the biggest of industry don’t have the veil of protection to catch ‘em, it gives smaller competitors a fairer chance to gain market share. A lot of good healing is done after the bleeding.