From both right and left the theme of the recent days has been the need to end too big to fail. The left seems to think this can be done by breaking up financial institutions, the right thinks it will be done by simply throwing financial institutions into chapter 11, Lehman style. They're both wrong.
Breaking up financial institutions does very little to solve the real problem of too big to fail, which is really too interconnected to fail. The horizontal relationships between financial firms make them unlike other firms, and it really does not matter how big these firms are. So unless we are going to regress to some sort of Jeffersonian paradise without financial firms, breaking them up is at best an indirect solution to the problem. Remember that Long Term Capital Management was not actually that big, compared to the likes of Lehman or AIG.
On the other hand,the idea that we should simply allow financial firms to liquidate sounds good if you consider the firm in isolation, but really bad once you remember the firm is part of a larger economic system. Moreover, the argument seems to ignore recent history -- if the past administration was not able to commit to such a strategy, is it realistic to expect any politician to simply stand by while the economy unwinds?
In short, a more realistic option is to give politicians a system that provides for a soft landing - that is, the system can't be too harsh, because even though a harsh system may make sense from a philosophical perspective, it will never be used. But we also need a system that avoids what happens in AIG -- shareholders remaining in place, while taxpayers took on the risk of not getting repaid. Shareholders and creditors have to lose their position -- and management face the consequences -- just as they would in any other corporate bankruptcy.
For this reason, I'm not totally opposed to the Dodd bill. I do think a chapter 11 model makes more sense than an FDIC model, but the $50 billion fund actually makes some sense. Yes it shows that we're not going to stiff arm the financial firms, which might create moral hazard, but I really don't think the stiff arm threat is credible anyway. And at least the fund makes the industry pay for the cost of cleaning up its own mess -- although the $150 billion the House proposes is a much better number if we really want to make sure taxpayer funds are not used.
My ideal? A chapter 11 system, where the regulators can file an involuntary petition, no safe harbors for at least a period of time, so the firm can be sold or recapitalized, and use the $150 billion fund to provide short term DIP financing. And have real regulation, of all aspects of financial firms, not just the insured bits, ex ante to avoid problems.