Too Big to Fail

John Cochrane writes:

This is a key lesson. As Dodd-Frank spreads to insurance companies, equity mutual funds, and asset managers, we’re losing sight of the idea that asset risk regulation keeps anyone from ever losing money again is not a wise way to try to prevent a panic. It’s the nature of the liabilities that is the problem.

I learned in the crisis that determining which firms are systemically important—which are TBTF—depends on economic and financial conditions. In a strong, stable economy, the failure of a given bank might not be systemic. The economy and financial firms and markets might be able to withstand a shock from such a failure without much harm to other institutions or to families and businesses. But in a weak economy with skittish markets, policymakers will be very worried about such a bank failure. [Kashkari]

In other words, the whole idea of designating an institution that is per se “systemic” is silly.

…there is no simple formula that defines what is systemic. I wish there were. It requires judgment from policymakers to assess conditions at the time. [Kashkari]

Here I think Kashkari isn’t really learning the lesson. If it’s undefinable and needs “judgment” then perhaps the idea really is empty.

More deeply, I think we need to apply much the same thinking to regulation that we do to monetary policy. At least in principle, most analysts think some sort of rule is a good idea for monetary policy. Pure discretion leads to volatility, moral hazard, time-inconsistency and so on. We should start talking about good rules for financial crisis management, not just ever greater power and discretion to follow whatever the “judgment” (whim?) of the moment says.

Yes, yes and yes. The rest of the post is pretty good too.


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