U.S. Markets open in 3 hrs 28 mins

Charles Plosser’s must-know solution to “too big to fail”

Phalguni Soni

Why Charles Plosser calls for simplicity in financial regulation (Part 7 of 9)

(Continued from Part 6)

“Too big to fail”

Dr. Charles Plosser, President and Chief Executive Officer of the Federal Reserve Bank of Philadelphia, spoke on “Simplicity, Transparency, and Market Discipline in Regulatory Reform” at a joint conference held at the Philadelphia Fed on April 8, 2014. Plosser provided a high-level perspective on financial regulations and financial stability. In the previous article of this series, we discussed what Plosser said with regard to market discipline and how transparency relates to market discipline. In this part, we’ll discuss his views on effectively leveraging market discipline and the addressing the problem of “too big to fail.”

As we mentioned in Part 1, Plosser advocated for preserving the independence of the U.S. Federal Reserve by drawing a distinction between fiscal and monetary policies after the fallout of the 2008 financial crisis. He’s also a keen proponent of reform that will end the notion of “too big to fail,” as he believes this notion may lead to the next financial crisis.

According to Plosser, “If creditors perceive they will be rescued, then market discipline is undermined and moral hazard will lead to greater risk-taking by the institutions. It is important to recognize that the moral hazard problem is not mitigated by eliminating the potential for government support. It doesn’t matter where the money comes from to rescue creditors. Any means of providing an implicit or explicit subsidy to protect creditors undermines market discipline and creates moral hazard. Without an effective and credible resolution regime that ensures no subsidies to creditors, there is less incentive for markets to monitor a firm’s risk—thus, the firm’s risk would not be accurately reflected in security prices.”

There have been numerous instances in the past few years of the federal government stepping it, using the theory of “too big to fail.” Some of the major instances include:

  • The bailout of Bear Stearns in March 2008 and its subsequent acquisition by JP Morgan Chase (JPM)
  • The federal government’s ~$188 billion takeover of Fannie Mae (FNMA) and Freddie Mac (FMCC) in September 2008
  • The Wachovia incident in September–October 2008, when the government arm-twisted Citigroup (C) into acquiring the bank—however, despite the government’s efforts, Wachovia was ultimately acquired by Wells Fargo (WFC) for ~$15.1 billion without government support

The next part of this series will discuss Plosser’s views on the Dodd-Frank Act and why the reforms it proposes are unlikely to end “too big to fail.” To find out more, please read on to Part 8.

Continue to Part 8

Browse this series on Market Realist: