Financial Regulation Reform and Too Big to Fail

Perhaps the leading critique of the Dodd-Frank Act is that it does too little to address the problem of too big to fail (“TBTF”) financial institutions. The critique of TBTF institutions has two main components. The economic argument focuses on a major moral hazard problem. The political argument focuses on the political clout of TBTF institutions. There are important truths in both the economic and the political argument against TBTF institutions. However, there are also important limits to the truth of both arguments. I believe the limits are more central than the truths, and that if anything Dodd-Frank has gone too far in focusing on TBTF institutions. This paper first explores the truths and limits of the economic argument, and then does the same for the political argument. It then lays out a map for my own preferred approach to the TBTF problem. In the short run, we need relatively modest but firm regulation. Dodd-Frank looks pretty good in many ways, but still needs some important fixes. The longer run is more daunting: we need to find ways to develop alternative financial and other institutions that are smaller and more focused on community and other stakeholder interests