EFF: The term "systemic risk" is less than 20 years old. It has become a scare term that governments use to justify bailout actions detrimental to taxpayers.
"Too big to fail" is an especially perverse use of the systemic risk scare tactic. I think the policy rule should be "too big not to fail," that is, big losers among financial firms get shut down first, to signal other big financial firms that "too big to fail" bailouts are over, so the firms will behave more responsibly in the future.
I have a white paper on these issues in the Essays section: "Government Equity Capital for Financial Firms."
KRF: Yes, there is systemic risk. The failure of one large bank, for example, can inflict significant losses on its trading partners, including other banks. The impact of these losses can, in turn, propagate through the general economy by reducing the other banks' willingness or ability to lend to their customers.
Gene is right about the consequences of a "too-big-to-fail" policy. They are awful. Reasonable people can disagree, however, about whether the consequences of allowing more—or even most—large banks to fail last October would have been even worse.
The long-term solution is to credibly repudiate the too-big-to-fail policy by (i) reducing the likelihood that large banks will suffer losses that exceed their equity cushion; (ii) expediting the resolution of distressed banks, so they impose fewer costs on the economy when they do fail; and (iii) possibly limiting the activities of banks so, for example, deposit-taking institutions are not threatened by proprietary trading losses. The Squam Lake Working Group on Financial Regulation, of which I am a member, is working on these and a variety of related issues.
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