Letting Go of Binary Thinking and Too-Big-To-Fail: Preserving a Continuum Approach to Systemic Risk

Abstract:     
This Article highlights differences between principle and practical implementation of prudential regulation and resolution rules pertaining to financial institutions. In principle, even though general prudential regulatory rules reflect a gradual risk-based continuum approach, their implementation with respect to large systemically important institutions has often been through regulatory forbearance. Particularly when confronted with lobbying pressure from very large banks, regulators have opted for inaction. In ironic contrast, statutory and regulatory resolution rules over time have increasingly restricted regulators’ options, often apparently leaving regulators to make a binary choice between letting the entity fail and providing a major government rescue or “bailout.” In reality, however, regulators have adopted a range of government strategic responses to imminent or actual large private business failures. Resolution authority is binary in principle, but actually implemented along a private-public continuum. Despite Dodd-Frank’s attempt to limit this “reality,” regulators are likely to continue to exercise their resolution authority in a more flexible manner along this continuum than might otherwise appear from formal and statutory rules.

Such a continuum-based approach is important for both regulation and resolution. On the regulation side, this approach suggests better implementation of the risk-based principles already in place and assurance that new enhanced prudential regulatory rules will be properly implemented. On the resolution side, it means understanding that resolution authority reflects government policy with respect to allocating large financial entity failure risks. Rather than pretend to rid the system of bailouts, regulators should acknowledge the range of existing and potential government responses to risk allocation, and work toward developing an equitable and transparent process and substantive criteria for making allocative choices in the case of systemically important financial institution failures.

Number of Pages in PDF File: 99

Keywords: Systemic risk regulation, financial regulation, bailouts, Dodd-Frank

Accepted Paper Series