Paradise Lost: Addressing Too Big to Fail

Sometimes it helps to contemplate economic predicaments by seeking wisdom from definitively noneconomic sources. Consider this passage from Book III (lines 98-102) of Milton's Paradise Lost, where God answers the question of why He created men and angels who could rebel against Him. Of man, He responds: I made him just and right, Sufficient to have stood, though free to fall. Such I created all th' ethereal Powers And Spirits, both them who stood and them who failed; Freely they stood who stood, and fell who Fell. As is clear from this most celebrated work of literature, the issue of whether entities--be they mortal or divine--should be allowed to fail is one of the oldest philosophical quandaries. It has been debated for eons on a much higher plane than economics or finance. And yet Milton is germane to the vexing issue of institutions considered "too big to fail. " There is no way we can reasonably expect to restore global financial stability without addressing that issue. Unintended Consequences Only a short while ago, we were teetering on the brink of global financial collapse. Essentially, what occurred was a crisis of unintended consequences: Misperceptions of risk trod misplaced incentives led to misguided actions. The crisis metastasized in large financial institutions and spread through the entire body of the financial system. Both on and off balance sheets, banks levered up to cancerous levels and funneled funds into assets of questionable quality. These bad bets were made worse by their scale and the rapidity with which they spread. It was not enough that one or two large institutions erroneously thought that real estate prices would rise forever--nearly 'all of the biggest banks did. It was not enough that one or two large institutions thought they could contract with third parties they presumed would immunize them against failure--nearly 'all did. And it was not enough that one or two regulators turned a blind eye to the systemic risk posed by this behavior--nearly all did, including the Federal Reserve. This is not something new. Readers of history might recall Charles Mackay's 1841 Memoirs of Extraordinary Popular Delusions, in which he wrote: "Every age has its peculiar folly--some scheme . or phantasy into which it plunges, spurred on by the love of gain, the necessity of excitement, or the mere force of imitation" (Mackay 1841: vol. 2, p. 1), to which he caustically added, "Men . think in herds; it will be seen that they go mad in herds" (Mackay 1841: vol. 1, p. 3). Or they might note this from Walter Bagehot's essay on Edward Gibbon in the National Review in 1856: "[A]t particular times . people have a great deal of . money. [They] seek for some one to devour it, and there is [a] 'plethora'--it finds some one, and there is 'speculation'--it is devoured, and there is 'panic'" (Bagehot 1856: 2). Or Dickens's bon mot, where he defined insurance as: "[a] person who can't pay, gets another person who can't pay, to guarantee that he can pay" (Dickens 1895: 259). How different things might have been if financial actors had kept the most human instincts of "love of gain" and "necessity of excitement" from leading them to become accomplices to herd-like imitation and uninsurable speculation. This behavior begat a panic where, but for the intervention of the Federal Reserve and other central banks, the entire payments system froze and brought the world economy within a hair's breadth of depression. Having staved off the inevitable consequence of the pathology I have just summarized, it is high time to treat the most malignant of its perpetrators--financial institutions thought to be too big to fail--as we refashion, modernize, and provide needed improvements to the regulatory system. The Need for an Overhaul Dan Tarullo (2009) from the Federal Reserve Board recently put it this way: The regulatory system did not come close to adequately accounting for the impact of trading, securitization, and some other capital market activities on both traditional banking and systemic risk. …