What is to be done with the nation’s largest financial institutions, 19 of which have been officially designated as “too big to fail?” When thus guaranteed government protection, such institutions can be expected to take excessive risk and generally operate recklessly. Profits on risky ventures remain privatized, while losses become socialized. That is what happens when you bet with other people’s (that is, taxpayers’) money. I have called the system “casino capitalism.”
The solution, of course, is to end the policy of “too big to fail.” That will not happen soon, however, and we will likely see the government’s safety net extended to more institutions before there is any prospect for its withdrawal. In the interim, the risk-taking appetite of the large banks must be constrained, that is, regulated. What should the classical liberal response be?
MIT’s Simon Johnson has argued, “Anything that is too big to fail is too big to exist.” He favors breaking these institutions up. Chicago’s Gary Becker has suggested imposing progressive capital requirements as a disincentive for financial services firms to grow large enough to become too big to fail. The larger the institution, the higher the required capital ratio.
What cannot in conscience be done is to apply presumptive free-market arguments to such entities. They are not being constrained by market forces. The market’s invisible hand has been replaced by the state’s protective embrace.