of a response to the too - big - to - fail problem, but there is good reason to doubt that they are sufficient. generally applicable capital and other regulatory requirements do not take account of the specifically systemic consequences of the failure of a large institution. it is for this reason that many have proposed a second kind of regulatory response – a special charge, possibly a special capital requirement, based on the systemic importance of a firm. ideally, this requirement would be calibrated so as to begin to bite gradually as a firm ’ s systemic importance increased, so as to avoid the need for identifying which firms are considered too - big - to - fail and, thereby, perhaps increasing moral hazard. while very appealing in concept, developing an appropriate metric for such a requirement is not an easy exercise. there is much attention being devoted to this effort – within the u. s. banking agencies, in international fora, and among academics – but at this moment there is no specific proposal that has gathered a critical mass of support. a third regulatory change is in some respects the most obvious and straightforward : any firm whose failure could have serious systemic consequences ought to be subject to regulatory requirements such as those i have just described. at present, these apply only to firms that own a commercial bank – a regulatory gap that became painfully evident last year as systemic problems arose from the activities of other firms. although the five large, " freestanding " investment banks of early 2008 have subsequently either converted to bank holding company status or ceased operations as independent firms, action by congress is needed to ensure that other firms posing such a risk – now or in the future – can be brought within the perimeter of regulation. this regulatory agenda has much to be said for it and should, i believe, be vigorously pursued. but i doubt that rules directed at the conduct of financial firms will be an adequate response to the too - big - to - fail problem. in the first place, there is some danger that simply piling on a series of administrative reforms and restrictions intended to constrain the behavior of firms would have unnecessarily adverse consequences for the availability of credit on risksensible terms for consumers and businesses alike. the interaction of regulatory changes needs to be thought through. also, the financial crisis should itself inject a considerable dose of humility into regulators ’ assessment of the efficacy of even well - considered regulations. rules directed at the behavior of large firms must be complemented with reforms directed at the behavior of their investors

institution, after a foreign depositor run that followed heavy losses. one concern arises from the effects on incentives of bank creditors and, possibly, the banks themselves. creditors who believe that an institution will be regarded by the government as too big to fail may not price into their extensions of credit the full risk assumed by the institution. that, of course, is the very definition of moral hazard. thus the institution has funds available to it at a price that does fully internalize the social costs associated with its operations. the consequences are a diminution of market discipline, inefficient allocation of capital, the socialization of losses from supposedly market - based activities, and a competitive advantage for the large institution compared to smaller banks. the management and shareholders of the too - big - to - fail institution may, in turn, regard themselves as holding a kind of put option and may thus be motivated to take greater risks the views expressed here are my own, and do not necessarily reflect those of other members of the board of governors of the federal reserve. with the cheaper funds now available to them. if the risky projects pay off, the shareholders profit famously. if the results are bad, the government may keep the institution afloat, thereby preserving at least some value for shareholders. the roots of the present crisis – and thus of the current form of the too - big - to - fail problems – reach much deeper than the breakdown of private risk management and shortcomings of government regulation during the first part of this decade. its origins lie in 30 years of change in the organization of financial firms and markets that squeezed the traditional business model of commercial banking. the regulatory system accommodated the growth of capital market alternatives to traditional financing by relaxing many restrictions on the type and geographic scope of bank activities, and virtually all restrictions on affiliations between banks and non - bank financial firms. the result was a financial services industry dominated by one set of very large financial holding companies centered on a large commercial bank and another set of very large financial institutions not subject to prudential regulation. many firms of both types relied for a considerable portion of their financing on short - term capital market sources that were often poorly matched with the maturity structure of a firm's assets. securitization markets were a major part of these complex, tightly wound financial arrangements. when questions arose about the quality of assets held by the borrowing institutions, a classic adverse feedback loop ensued. with lenders increasingly unwilling to extend credit against these assets,