A market-based regulatory policy to avoid financial crises.

• Author: Zingales, Luigi
• Position: Essay

When it comes to "saving capitalism," dealing with the "too big to fail" doctrine is a top priority. This doctrine has increasingly become the government policy on this issue, and it is probably the most dangerous policy for capitalism we can imagine. It undermines capitalism in many ways: not only does it make the system less stable, but it also undermines the moral basis of capitalism. If you have a sector or a set of institutions where losses are socialized but where gains are privatized, then you destroy the economic and moral supremacy of capitalism. Either we deal with the perverse incentives created by this doctrine or we undermine the long-term sustainability of capitalism. So it is really important to think what we can do against this too-big-to-fail policy.

What to Do about Too Big to Fail

I have spoken with many members of Congress and the best intentioned ones want to legislate the too-big-to-fail policy away by introducing enough constraints that will make it impossible in the future to do what the government has done in the recent crisis. In spite of their good intentions, I do not think that these members of Congress understand the essence of the problem. Let me use an analogy. As parents we know that we should let our children learn from their mistakes. We should not be too interventionist and bail them out, because they won't learn. However, when they get into real, serious trouble, when their life is in danger, it is impossible for us as parents not to intervene. It would be against nature not to intervene. And no matter how we can try to commit not to intervene because we know that this has good incentive effects on our children, when our son or daughter's life is in danger, we will intervene. And that's a little bit like the situation we are in with large financial institutions. No matter how much we try to tie our hands, when a major crisis comes it is impossible to stop the politicians from intervening. Part of the reason is that during a banking crisis a government intervention can actually create value (or at least avoid that value is dissipated) ex post. Politicians find it difficult not to intervene even in situations where they destroy value; imagine when they can create some value because they stop a bank run! As with the children example, however, this beneficial intervention has perverse incentive effects. For this reason, we need to introduce mechanisms to minimize the damage that this incentive will create in the system. If we ignore it, if we live...