The failure of ‘too big to fail’

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Editor's note: This is Part 3 of a multipart series. Read Part 1, "6 issues to steer financial reform," and Part 2, " 'Wind-down': a bailout alternative." "Too big to fail" is used to describe companies that, if they collapse, would have such devastating effects on the financial system as a whole that government is forced to protect their creditors. Such rescues are costly to taxpayers, politically disruptive, and, by establishing a rescue precedent, pave the way for even more costly rescues in the future. For reasons discussed last week, policies designed to convert too-big-to-fail (TBTF) firms into firms that are not TBTF are unlikely to be enacted. The alternative to rescuing such firms is to prevent them from getting into trouble in the first place by effectively regulating their risk exposures. But our regulatory history is not encouraging. The savings and loan industry, rocked by a different kind of crisis in the early 1980s, was regulated...