Too Big to Fool: Moral Hazard, Bailouts, and Corporate Responsibility

Abstract

The U.S. and foreign regulatory efforts to prevent another financial crisis have been converging on the idea of trying to end the problem of “too big to fail.” Regulators are concerned that systemically important financial firms will take excessive risks because they will profit by success and expect to be bailed out by government money in case of failure. Unfortunately, the legal solutions being advanced to control this moral hazard tend to be inefficient, ineffective, or even dangerous—such as breaking up firms and limiting their size, which can reduce economies of scale and scope; or restricting central bank authority to bail out failing firms, which (ironically) exacerbates the risk that an uncontrolled banking failure will trigger another crisis. This article contends that the too-big-to-fail problem is exaggerated; it shows there is no evidence, and that it is unlikely, that moral hazard causes systemically important firms to engage in excessive risk-taking. Such risk-taking is more likely to be caused by other factors, including a legally embedded conflict between corporate governance and the public interest that allows managers of those firms to ignore systemic externalities. The article argues that the law can, and should, address excessive risk-taking more directly by requiring those managers to account for systemic externalities in their governance decisions. It also argues for the creation of a privatized fund to minimize the public cost of bailing out systemically important firms that would fail notwithstanding reduced risk-taking.