“In short, TBTF is FUBAR.”
How does one deal with too these giant banks? It is believed widely that if one of the big banks were to implode the whole world might also collapse into a debt chain reaction ending in a monetary singularity.
How do we fight this possibility? We give power to the government to back these institutions, which then encourages the growth of these massive financial entities. This in turn compounds the first problem and creates a never ending expansion of moral hazard.
(From Real Clear Markets)
When a firm becomes too big to fail, the subsidy that comes with government backing and the competitive advantage this gives it over smaller banks cause the firm to become even larger. So it goes from being too big to fail to being really too big to fail. Yet at the same time, the safety net of a government bailout gives the bank’s managers an incentive to take on more risk. It frees them to chase higher returns (and bigger bonuses) without facing pressure from risk-averse shareholders or trading partners.
So we confront the problem of banks so big that they could destabilize the financial system–and we react by making them even bigger and less stable.
And that’s just the beginning. We face an even worse set of dilemmas when we contemplate how to end too big to fail.