Managing Risk in the Financial System
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Managing Risk in the Financial System

Edited by John Raymond LaBrosse, Rodrigo Olivares-Caminal and Dalvinder Singh

Managing Risk in the Financial System makes important and timely contributions to our knowledge and understanding of banking law, financial institution restructuring and related considerations, through the production of an innovative, international and interdisciplinary set of contributions which link together the law and policy issues surrounding systemic risk and crisis management.
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Chapter 13: Finding a Solution to the ‘Too-Big-To-Fail’ Problem

Arthur E. Wilmarth


13. Finding a solution to the ‘too-bigto-fail’ problem Arthur E. Wilmarth, Jr. 13.1. INTRODUCTION The financial crisis – widely viewed as the worst since the Great Depression1 – has inflicted tremendous damage on financial markets and economies around the world.2 It has revealed fundamental weaknesses in the financial regulatory systems of the US, the UK, and other European nations, making regulatory reforms an urgent priority. Publicly-funded bailouts of ‘too-big-to-fail’ (TBTF) financial institutions have provided indisputable proof that (i) TBTF institutions benefit from large explicit and implicit public subsidies, and (ii) those subsidies undermine market discipline and distort economic incentives for large, complex financial institutions (LCFIs).3 Accordingly, a primary objective of regulatory reforms must be to eliminate (or at least greatly reduce) TBTF subsidies, thereby forcing LCFIs to internalize the risks and costs of their activities. This chapter proposes five reforms designed to prevent excessive risktaking by LCFIs and to shrink TBTF subsidies in the US financial system.4 The proposed reforms would (1) strengthen current statutory restrictions on the growth of LCFIs, (2) create a special resolution process to manage the orderly liquidation or restructuring of systemically important financial institutions (SIFIs), (3) establish a consolidated supervisory regime and enhanced capital requirements for SIFIs, (4) create a special insurance fund for SIFIs in order to cover the costs of resolving failed SIFIs, and (5) rigorously insulate banks that are owned by LCFIs from the activities and risks of their nonbank affiliates. 13.2. REFORMING FINANCIAL REGULATION TO SHRINK TBTF SUBSIDIES The enormous competitive advantages...

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