Eliminating Wall Street's Safety Net: How a Systemic Risk Premium Can Solve "Too Big to Fail"

Jason Rudderman, Florida State University

Abstract

Eliminating Wall Street’s Safety Net: How a Systemic Risk Premium Can Solve “Too Big to Fail”

The financial crisis of 2007 – 2009 sent the United States and the global economy into its worst recession since the great depression. Large, interconnected financial and non-financial institutions were at the center of the financial crisis. The institutions highly leveraged positions during the crisis led the government to take extreme measures, including bailing out some of these “too big to fail,” but failing institutions. The crisis led the United States Congress to pass the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), the largest reform of the financial system in the United States since the Great Depression. The Dodd-Frank Act, among other objectives, purports to “promote the financial stability of the United States [and] to end ‘too big to fail.’”

This paper explores the necessary role of “too big to fail” institutions in our financial system, explores the sections of the Dodd Frank Act relevant to determining systemic risk and identifying “too big to fail” institutions, and offers a regulatory and economic framework for regulating “too big to fail” institutions in a manner that reduces moral hazard between the institution and the rest of the financial sector while protecting American ideals of capitalism and the free market. Part II of this paper briefly discusses the causes of the financial crisis and defines “too big to fail,” systemic risk, and contagion. Part III explores Title I and II of the Dodd-Frank Act and the relevant legislation aimed at eliminating the problem of “too big to fail” and reducing the overall risk inherent in the United State’s financial system. Part IV discusses the moral hazard problems in financial regulation and the “too big to fail” paradigm. Part V highlights gaps in the legislation, and explores alternative solutions to the “too big to fail” problem through additional regulation, information sharing, bankruptcy, antitrust and ultimately proposes a systemic risk premium.