It is not a good idea to try and limit the size of US banks or other financial institutions, which are in many cases smaller than foreign owned banks.  Size limits would encourage the industry to move offshore and would probably encourage institutions to make their portfolios more risky—if they have to cut out some of their assets they will cut out the ones making lower returns.  New York is a financial hub for the world economy and needs large banks to sustain its position.  Financial services have been one of our most successful export industries and we should not impose restrictions that make the US industry uncompetitive.

There is no perfect answer to TBIF but the two most promising approaches are as follows:  First, create a resolution authority (or a special bankruptcy court) so that large banks can be closed down in an orderly fashion without excessive disruption to the system as a whole.  The most difficult part of this approach is resolving international banks and that requires cooperation with other countries, especially other financial hubs such as London.  The resolution process should heavily penalize managers and shareholders and make bond holders take losses.  A special fund should be available to make sure the institution is kept operating until it can be sold off or shut down.  This fund should be drawn from a levy on other financial institutions, especially other large financial institutions.

The second approach is that financial institutions should be required to hold more capital the bigger and riskier they get.  The approach should not be punitive but should capture the additional risks imposed by large and complex institutions on the financial system as a whole.  Large banks should also be subject to additional scrutiny from regulators to make sure they are following sound risk management strategies.

The two biggest problems in the financial crisis were, first, that financial institutions did not have adequate risk management rules or did not follow them if they had them.  Second, regulators pored over the books of the banks but never really tested whether they were keeping their risks under control.  These problems were not specifically problems of size, but of poor management and regulatory practices and these must be changed going forward.

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There are means other than draconian limits on size to credibly prevent government bailouts of large institutions. And there are large social gains from retaining large, complex, global financial institutions.

As I argue more at length elsewhere, it is worth preserving large financial institutions four reasons. First and foremost, financial institutions need to be large to operate with global scope because their clients are large and global. Small, local banks simply could not provide global corporations the same physical capabilities for trade finance, foreign exchange contracting, and global capital access that large global financial institutions can. 

Second, there are production economies of scope that offer benefits when financial firms combine different products within the same firm. Economies of scope among products implies economies of scale within finance suppliers, since small financial firms cannot afford the overhead that comes from building platforms with many such complex products.

Third, many of the gains of consolidation accrued to customers, not banks, in the form of cheaper and better financial services. Among the many examples, perhaps the greatest accomplishment of global finance in the past two decades has been the replacement of crony banking networks in emerging market countries with branches of large global banks. 

Fourth, global financial institutions also have made stock, bond, and foreign exchange markets globally integrated and more efficient.

We can solve the too-big-to-fail problem without destroying global finance.

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Clearly, we have one big “too big to fail” problem, and thus it is tempting to go beyond the antitrust laws and begin breaking up the largest financial institutions to sizes a bit smaller than the TBTF threshold. While I have more confidence in defining where that threshold may be for purposes of stronger systemic oversight, I am less confidence in our collective ability to define that threshold purposes for actually breaking up existing enterprises. We don’t fully know, despite countless regressions, where economies of scale ends and diseconomies of size begin More importantly, the act of breaking up existing entities could entail significant efficiencies of its own: what do you with the financial conglomerate that centralizes its IT functions? And also I worry that a hard limit on size would encourage end-arounds – more different kinds of structured investment vehicles ostensibly off balance sheet or off the size czar’s radar screen ; and if these devices didn’t work, large organizations just below the threshold would have no more incentives for internal growth and innovation.

I am far more comfortable with a regulatory system that gradually penalizes size, however, through progressive higher capital/liquidity requirements. A graduated system of regulatory obligations would more consistent with market-principles, and let the organizations and the market figure out how to best cope with the higher costs their size (and inter-connectedness) impose on the financial and economic system as a whole.

Furthermore, to the extent it does not generate excessive costs of its own, large troubled financial institutions that are being resolved by the authorities (under needed new legislation, giving regulator bank-like resolution powers) should b dismembered so that they don’t come back to haunt us again. But regulators also should have the option not to conduct surgeries if they are significantly more expensive than what they would otherwise do to meet a “least cost resolution” standard.

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Yes. In Congressional testimony and elsewhere I proposed that the Congress should limit too big to fail, leaving the choice of size to the bank. The rule should require banks above moderate size to increase capital more than in proportion to their increase in asset size. That would shift risk from taxpayers to bank owners. As part of this change, Congress and the Federal Reserve should agree on a lender of last resort rule to encourage counterparties of failed banks to hold collateral that the Fed will accept for discounts.