By Kindred Winecoff
Suppose policymakers send a clear signal: banks that are "too big to fail" will be bailed out, so in return they must bear a stricter regulatory burden. Banks that are not too big to fail will not be bailed out, so they have a laxer burden. What incentive does that give to banks... get bigger to capture the guarantee, or get smaller to avoid the stricter regulation?
Depends on the regulation. But I don't see any large bank responding to Basel III or Dodd-Frank or any other regulatory change by desperately trying to reduce size. That should provide some indication of what margin we're operating at. And even if the banks are small enough to fail without systemic consequences, that doesn't necessarily mean their creditors are:
Governments across the world are committed to allowing banks to fail in the future. Socialising bank losses is unpopular, and it creates moral hazard. However, when national banking sectors remain fragile, imposing burden-sharing resolution regimes is fraught with danger. Governments and regulators may chose safety first. Witness the ECB’s continuing refusal to allow haircuts for the senior bondholders of Irish banks. They, it seems, are definitely too big to fail.
Also remember 1907. The problem then wasn't "too big to fail". It was "too small so they failed". Larger institutions gain greater confidence than smaller institutions. The 1907 panic stopped only after JP Morgan (the man) intervened, so says the myth. That strategy repeatedly failed in 1929, as Galbraith's The Great Crash notes, but in 2008 the crisis may have been much worse if huge institutions didn't exist to merge with other huge institutions. Small institutions can't easily take on others' balance sheets in times of trouble, at any price.
The point is that there are downsides to decentralized finance. TBTF is a real problem, but it's not the only problem. Constructing regulations to punish TBTF firms could actually reward them. I can easily imagine Wall Street executives wearing their SIFI ("systemically important financial institution"*) designations as badges of honor. And counting on them as explicit blank checks from governments. Who wouldn't want a SIFI as a counterparty? Almost as good as a GSE.
*Subject to stricter capital requirements under Basel III.