The most traumatic and disruptive feature of the recent financial crisis was that the government was forced to rescue firms that had behaved recklessly. These firms were "too big to fail," meaning that the repercussions of their failure could have destabilized the entire system.

The best analysis of this problem that I have seen is in "Wind-down Plans as an Alternative to Bailouts: The Cross-Border Challenges," by Richard Herring, a Wharton colleague. I have drawn heavily from his paper.

Too-big-to-fail (TBTF) firms in some cases provide services that are critical to the functioning of markets, such as acting as a dealer or providing settlement or escrow services. In some cases, they own many hundreds of affiliates in foreign countries, failure of which become problems for each country’s regulators, who may or may not talk to each other.

Editor’s note: This is Part 2 of a multipart series. Read Part 1, "6 issues to steer financial reform," and Part 3, "The failure of ‘too big to fail.’ "

The most traumatic and disruptive feature of the recent financial crisis was that the government was forced to rescue firms that had behaved recklessly. These firms were "too big to fail," meaning that the repercussions of their failure could have destabilized the entire system.

The best analysis of this problem that I have seen is in "Wind-down Plans as an Alternative to Bailouts: The Cross-Border Challenges," by Richard Herring, a Wharton colleague. I have drawn heavily from his paper.

Too-big-to-fail (TBTF) firms in some cases provide services that are critical to the functioning of markets, such as acting as a dealer or providing settlement or escrow services. In some cases, they own many hundreds of affiliates in foreign countries, failure of which become problems for each country’s regulators, who may or may not talk to each other.

TBTF firms also are likely to have credit and other obligations in such large volume and to so many other firms that a failure to pay could panic investors and cause markets to freeze.

The need to rescue TBTF firms was underscored by the Lehman Brothers case, where officials could not find a legal way to effect a rescue in time; the ensuing disruption was devastating.

Herring notes that "Lehman’s bankruptcy has led to civil proceedings on three continents where transactions were aborted in the middle of the clearing and settlement process." He notes that about 43,000 transactions are still open and have yet to be negotiated or litigated.

The unstated policy adopted after the Lehman failure was that no more Lehmans would be permitted because the costs were excessive. But the cost of rescues is also staggeringly high.

The immediate cost of rescue operations is the expenditure of public funds to protect the creditors of TBTF firms. The long-run cost is that the rescues of TBTF firms that have already occurred increase the likelihood that even more costly rescues will be needed in the future.

The high probability of rescue gives firms an incentive to become TBTF if they are not one already. TBTF firms enjoy a competitive advantage based not on their efficiency or customer service, but simply on their being TBTF.

Because their creditors are confident that they will be protected, there is no need for creditors to monitor the soundness of the TBTF firms to whom they entrust their money, which encourages TBTF firms to earn more by taking more risks. In short, if the problem is not fixed, it will get worse.

Nothing that has been proposed by the administration or the Congress to date will eliminate TBTF firms. Size restrictions will probably be adopted but will have little impact unless they require widespread downsizing, which nobody is proposing. …CONTINUED

The proposal for a governmental resolution authority that, in former Federal Reserve Chairman Paul Volcker’s words, "should be authorized to intervene in the event that a systemically critical capital market institution is on the brink of failure" might make the rescue process more orderly and less frenzied, but it won’t stop rescues.

On the contrary, it will probably make rescue more certain by eliminating the possibility that government won’t be prepared to take action. Had such an authority been involved in the Lehman case, it is almost certain that Lehman would have been rescued.

A government resolution authority would have more muscle if it could require that all systemically important firms develop an approved "wind-down plan," which would specify exactly what the firm would do in the event that it became insolvent.

Herring has a detailed description of exactly what a wind-down plan should include. To be approved by regulators, the plan would have to show how the firm would wind up its affairs, and those of all of its affiliates, in a reasonable time frame and without any adverse spillovers to other firms.

This approach would be fiercely resisted by TBTF firms and would be extremely challenging for regulators to implement effectively.

If successful, wind-down plans would eliminate or reduce disruption costs, such as those that result from the aborting of transactions in process, but it is not at all clear that it would eliminate the perceived need to protect creditors. A wind-down plan won’t necessarily prevent a contagious loss of confidence if the firm doesn’t pay its debts.

It follows that equal if not greater emphasis ought to be given to preventing TBTF firms from getting into trouble in the first place. That is the topic of next week’s article.

The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

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