Financial institutions ; Banks and banking, Central

Jeffrey M. Lacker

English

Research Papers in Economics

Winter 2009 • Region Focus 1
JEFFREY M. LACKER
PRESIDENT
FEDERAL RESERVE BANK OF RICHMOND
Time to Rethink “Too Big To Fail”
T
he cover story of this
issue of Region Focus 
discusses the U.S. cor-
porate bankruptcy system. The
article points out some of the
strengths and weaknesses of
that system, from the stand-
point of economic efficiency.
The system is not perfect. 
For instance, firms that are no
longer economically viable may
be able to find sympathetic
judges who postpone liquida-
tion beyond a period that would be optimal for the
economy as a whole. It would be better, in some of those
cases, to expedite the liquidation, freeing up valuable
resources that could be more effectively used elsewhere. 
But, in the main, the corporate bankruptcy system,
which has evolved over many decades, works relatively 
well. It provides an opportunity for fundamentally sound
companies that are experiencing temporary difficulties to
reorganize and get back on their feet. And it includes 
measures that guide the orderly closing of firms which 
cannot effectively compete in their respective markets. 
An example of such a firm, which the article discusses in
some detail, is the electronics retailer Circuit City, based
here in Richmond. It operated in an extremely competitive
environment in which consumers are highly discriminating.
Ultimately, enough of those consumers opted to shop with
Circuit City’s competitors that the firm could not survive.
For many of the former employees of Circuit City, this is no
doubt painful. The change that results from competition is
not always pleasant, but it is essential to the functioning of
a healthy market economy. 
For most sectors of the economy, policymakers recognize
that there should and will be frequent change, including the
failure of some firms. And the corporate bankruptcy system
helps to facilitate those closures in a way that is generally
beneficial to the economy.
There are, however, a few exceptions: sectors that many
policymakers believe include firms which simply cannot be
allowed to fail. The most obvious example is the financial
sector. Financial institutions are, of course, crucial to a mar-
ket system. They provide the liquidity needed by businesses
across the economy. But because of their unique function in
the economy, should they be protected from failure?
That is a difficult question. It is possible that the failure
of a particularly large firm could cause great harm to the
economy. But first we should ask why so many big financial
institutions came under enormous stress over the past year.
PRESIDENT’SMESSAGE
There are several reasons, to be sure, but a significant factor
was that many of them believed they were “too big to fail” —
that is, they were willing to take excessive risks because they
were confident they enjoyed either explicit or implicit pub-
lic support. And, of course, such support has been
forthcoming in numerous cases.
As a result, some people have called for the creation of a
systemic risk regulator to oversee all financial institutions.
Ultimately, such a regulator could prove useful, though I am
generally skeptical of the idea. One thing seems clear, 
however. Redesigning our financial regulatory system 
before establishing clear boundaries around the federal
financial safety net — boundaries that I believe should be
much tighter than at present — would be like putting the
cart before the horse. 
The financial crisis should lead us to think hard about the
incentives that financial institutions face — and what we
can do to reform them to bring greater stability to the 
system, while at the same time not discouraging innovation.
At the top of the list is rethinking whether “too big to fail”
protections move us toward that goal or away from it.
RF_WINTER_2009  4/23/09  9:58 AM  Page 1

President's message : Time to rethink "too big to fail"

http://www.richmondfed.org/publications/research/region_focus/2009/winter/pdf/presidents_message.pdf

President's message : Time to rethink "too big to fail"

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics