NY Fed Speech: "Solving the Too Big to Fail Problem"

William Dudley, president of the Federal Reserve Bank of New York, gave a speech at the Clearing House's Annual Business Meeting titled "Solving the Too Big to Fail Problem". Dudley stated the problem in two parts: (i) whether society should tolerate a financial system in which certain financial institutions are deemed to be too big to fail, and (ii) if not, what we should do about it.

To the first question, Dudley stated that the answer is "clearly" that "we cannot tolerate a financial system in which some firms are too big to fail--at least not ones that operate in any form other than that of a tightly regulated entity." He argued that the root cause of "too big to fail" is that the failure of large, complex financial firms generate large, undesirable externalities in our current financial system. He noted that although there are negative externalities associated with the failure of any financial firm, these externalities are disproportionately high in the case of large, complex and interconnected firms.

As to the question of how to tackle the problem, Dudley stated that measures should include both those that are firm-specific and those that address the structure of the financial system more broadly. Firm-specific measures alter incentives for excessive risk-taking and lower the probability of failure, while structural measures lessen the disruption to the financial system that a failure would impose on the economy and society at large. Dudley mentioned the new Basel regime as an example of firm-specific policies that alter incentives, and the "living will" process as an example of policy measures to reduce the systemic consequences of failure.

Dudley also addressed the argument that "too big to fail" firms should be broken up now. He stated that while this could eventually prove necessary, it would be "premature" to give up on the current approach: "changing the incentives facing large and complex firms, forcing them to become more resilient, and making the financial system more robust to their failure."

Click here to view speech in full (links externally to NY Fed website).