iMFdirect – The IMF Blog

By José Viñals

Over the past two years, disruptive failures, shotgun marriages, and government bailouts of some household names in the financial industry have placed the age-old issue of “too big to fail” at the center of financial sector policy discussions. As well, the Lehman bankruptcy and government support for AIG extended the “too-big-to-fail” notion from banks to include nonbank financial institutions. And in some cases, the financial institutions in distress were not even particularly big; rather, they were too interconnected, and too important for the functioning of the global financial system, to be allowed to fail.

We need to think about how to deal with such “too-important-to-fail” institutions for at least three reasons. 

• When institutions are provided with implicit (and explicit) public support, they are apt to take on riskier activities than they otherwise would, with the knowledge that the government will step in if those risks turn out badly. This is called moral hazard. 
• Well-run institutions are forced to compete with institutions that are implicitly guaranteed—or even directly financially supported—by the government. This makes for an unlevel playing field in the financial sector. 
• Government support absorbs valuable public resources, arguably at the expense of more equitable and productive public spending; it could also endanger the fiscal stability of a country.

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Filed under: Economic Crisis, Financial Crisis, Financial regulation, recession | Tagged: AIG, capital requirements, financial sector supervision, Financial Stability Board, G-20, José Viñals, risk | 1 Comment »