Overcoming Too-Big-To-Fail: A Regulatory Framework to Limit Moral Hazard and Free Riding in the Financial Sector

Following the demise of Lehman Brothers, the debate on regulatory reform has centered around whether large financial institutions must be broken up and their risk-taking activities limited by law, as called for by the "Volcker rule." This report argues that such actions are by no means necessary, may be hard to implement in practice, and could entail large costs in terms of the availability of credit to the economy (e.g., if they reduced the ability of banks to hedge their credit positions).

Alternative solutions exist that can achieve a more stable and resilient financial system without renouncing the benefits of multi-purpose financial institutions and innovative finance. These are predicated on effectively curtailing moral hazard and strengthening market discipline on banks' shareholders and managers by raising the cost of the banking charter to reflect fully its benefits for the banks, and on restoring the possibility that all or at least most financial institutions could go bust without triggering unmanageable systemic repercussions.