Don't Forget Too Big to Fail

A former Citigroup chairman and a partner at Roaring Brook Capital (founded by a former Merrill Lynch executive) issue their recommendations for financial reform in the WSJ:

One thing our public officials should not do is get caught up in a debate over "too big to fail." It's a catchy phrase, but that's about it. Indeed, it is important to recognize that our recent financial crisis was provoked by last year's failure of Lehman Brothers, a company that few, if anyone, would have argued was too big to fail. Rather than get side-tracked on this and other complex questions, our policy leaders should focus directly on how to create and enhance market discipline.

Citigroup, of course, is the biggest of the "too big to fail" institutions.

Yes, these are "complex questions." But the authors take the complexity as a reason to not even consider what's wrong with declaring certain institutions too big to fail. Instead, this issue is so complex precisely because it's so important. So important that it makes it very difficult to "create and enhance market discipline" if you ignore the effects of bailouts.

If a firm knows a bailout is coming if it does anything wrong, market discipline is no longer in play (or, at the very least, its incentives to perform in the market are decreased). The evidence is pretty strong that the cycle of bailing out firms, followed by a period of booms, then crash, then another bailout, is one that is created by politicizing big companies rather than letting market discipline take hold.