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How Do We Resolve the Too-Big-to-Fail Problem?
The Vickers Commission in the United Kingdom has advocated ring-fencing of core banking activities; the Volcker Rule in the United States prohibits banks from engaging in certain kinds of investment activities. Neither will be easy to implement and neither is likely to be very effective. To deal with the risks posed by systemically important financial institutions what is needed is a multi-pronged approach that addresses size, concentration and ownership structure and far more intrusive regulation than we have seen in the recent past. An important element in this approach must be the presence of a few large banks in the public sector.
The sub-prime crisis of 2007, the consequences of which are still being felt by the world economy, highlighted glaring deficiencies in the regulation of banks and in the financial sector in general. A number of measures have been taken both at the international level (under the auspices of the Bank for International Settlements (BIS)) and by national regulators by way of tightening bank regulation. Perhaps the most comprehensive is the Dodd-Frank Act (2010) passed in the United States (US).
A fundamental problem that remains unresolved is what is called the too-big-to-fail problem or the problem posed by systemically important financial institutions (SIFIs). Banks that are very big (in relation to the size of their economies) cannot be allowed to fail because the failure of these would cause significant disruption in the economy. Knowing this, managers at these banks can take enormous risks. If these work out, they will collect big rewards; if they do not, the government will rescue them. Given these incentives for inappropriate behaviour, regulation of SIFIs poses enormous challenges.
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