A Continuum Approach to Systematic Risk and Too-Big-to-Fail

Cheryl Block | 6 Brooklyn Journal of Corporate, Financial, and Commercial Law 289 (2012)

This Article highlights differences between principle and practical implementation of prudential financial regulation and resolution rules for failing financial institutions. In principle, prudential regulation gradually enhances enforcement along a risk-based continuum. Under this approach, systemically important financial institutions, which pose greater potential threats to economic stability, theoretically should be more strictly regulated than other financial entities.  In reality, however, regulators often opt not to fully enforce prudential financial regulations against such large institutions, a practice sometimes referred to as regulatory forbearance. In ironic contrast, rules for resolving failing financial institutions have increasingly restricted regulators’ options, often limiting them to a binary choice between allowing the entity to fail and providing a government “bailout.” In reality, however, regulators have flexibly responded to failing institutions along a continuum ranging from little or no intervention to public rescue. Despite Dodd-Frank’s attempt to limit this “reality,” regulators are likely to continue the flexible exercise of their resolution authority. In this Article, I argue that a continuum-based approach is important for both prudential regulation and the resolution of failing firms. With respect to regulation, this approach should ensure proper implementation of existing gradually enhanced prudential regulatory rules. With respect to resolution, this approach acknowledges and accepts the range of existing and potential government responses to failing financial institutions. Rather than pretend to rid the system of bailouts, policy makers should develop an equitable and transparent process and substantive criteria for allocating risk in the event of systemically important financial institution failures. more... 

Faculty Scholarship