David Wessel has a column in today’s Wall Street Journal laying out three approaches to solving our Too Big Too Fail (TBTF) problem. The first two amount to different ways of “busting them up,” as Wessel puts it. The third, which the administration and the Fed have endorsed, amounts to forcing banks to hold more capital, scrutinizing their balance sheets more vigorously, and obtaining some sort of “resolution authority.” That last reform would allow the government to liquidate a megabank in an orderly way (like the FDIC does with smaller banks), rather than either bail them out entirely or simply let them implode, a la Lehman Brothers.  

I happen to support every one of the administration’s proposals on this score. But, despite their merits, I’m not convinced they address the consequences of bigness. For that, we probably do have to talk about shrinkage.

To see why, you need to start with what the TBTF problem actually is, which Wessel helpfully explains:

Investors who lend to or trade with these firms, for good reason, believe taxpayers will stand behind the debt of TBTF firms if things go bad. So, these firms can borrow more cheaply than too-small-to-save firms. That taxpayer subsidy -- and that's what it is -- means these institutions can make riskier bets, collecting rewards if they win and sticking taxpayers with the tab if they don't.
 
This is an old problem. But the rescues of Bear Stearns and American International Group and the uproar over the Lehman Brothers bankruptcy have expanded it beyond ordinary big banks. The past year has established a pattern: Executives of TBTF firms may be fired and their shareholders squeezed, but bondholders and trading counterparties will be protected.

The administration proposal that gets at this problem most directly is resolution authority. As I understand it, the key part of the proposal is to require banks to have a so-called "living will"--basically a road map that would guide the government on how to value and unwind all the assets on the bank’s balance sheet.

So, if a megabank were about to fail, the government would show up on a Friday evening and consult the will. Over the weekend, it would transfer its customers’ accounts to another bank and sell off the pieces that were critical to the functioning of the financial system (for example, the bank’s payments business—which routes money from one party to another when you use things like credit cards or debit cards). The government would probably also sell off its derivatives portfolio, so that its counterparties (i.e., the people on the other side of all its risky bets) don’t freak out. The “living will” would provide a decent sense of what all these things were worth.

No less important, the living will would also help value the businesses—things like investment banking, mortgage lending, etc.--that didn't get sold immediately. So even if selling them took a long time, the government could settle up with the bank’s bondholders before the markets opened Monday morning. It might give the bondholders, say, 60 cents on the dollar, then pay itself back as the other businesses were liquidated.

The basic idea is that, because the whole affair is orderly and controlled, the financial markets will take it in stride, and it wouldn’t cause collateral damage the way Lehman did. Furthermore, because bondholders are taking a so-called haircut—i.e., recovering only 60 cents of every dollar they lent rather than the full dollar—you solve the problem Wessel describes, which is that bondholders will lend cheaply to finance risky bets when they know they’ll be bailed out. Not anymore, says the administration. Hereafter, investors will have to price in the risk of failure, which will make it more costly for TBTF banks to borrow and will rein in their risk-taking.

All in all, it's a very sound proposal. But here’s my concern: Almost by definition, you’re going to be in the middle of a financial crisis (or at least a period of severe stress) if a megabank is on the verge of collapse. At a moment like that—think back to last fall—will Treasury and the Fed have the courage to only pay bondholders 60 cents on the dollar? After all, there’s a very real risk they’ll surprise the credit markets with their stinginess, which could lead bond investors to stop lending money and seize up the whole financial system—the very thing the federal government wanted to avoid.

And even if the feds did have the courage to give bondholders the hair cut they deserve, are the bondholders going to believe that ex ante—that is, at the time they’re loaning money to these TBTF banks? If they don’t believe it, then they’re going to lend cheaply, which is going to help the TBTFs take outsized risks, which brings us right back to where we were. Now maybe all it takes is putting one megabank through receivership to show that the government is serious. But the soonest that would probably happen is several years from now (that is, during the next financial crisis; here’s hoping it doesn’t come sooner), which is a lot of time for TBTF banks to dine out on cheap credit and place ill-advised bets.

On top of which, there’s the whole problem of politics. That is, it’s not even clear that a megabank like Citigroup or Bank of America would let itself be liquidated by the federal government. We’re not talking about some local thrift that’s powerless before the FDIC (which seizes and resolves smaller banks). Megabanks have a ton of political power, both by virtue of having big lobbying operations and lots of wealthy executives (who donate money to politicians), and by virtue of employing a massive number of people, many of whose jobs would disappear if the bank were sold off in pieces. Citigroup, for example, has 300,000 employees. It’s hard to believe that the potential loss of tens of thousands of those jobs wouldn’t make the feds think twice before putting it into receivership. Which is to say, as a practical matter, the government may not have any choice but to bail out a TBTF bank, even if it has resolution authority.

Don’t get me wrong: As I say, resolution authority is an unambiguous step in the right direction. More policy tools are always better, and this certainly could work under certain circumstances. But my gut says the only reliable way of preventing big firms from borrowing cheaply to finance crazy bets is to shrink them. They need to be small enough so that a freak-out by their bondholders wouldn’t massively roil the credit markets, and so that they don’t have the political power to push back against liquidation. And that means they have to be much, much smaller than they are today.

Update: Tim Fernholz takes the other side of the argument over at the Prospect.

Update II: It's worth pointing out that higher capital requirements in themselves should restrain bigness. They reduce profits on particular bets and, if they're structured so that they rise in increasing proportion to size, can directly make it costlier for a firm to get bigger. Relatedly, the living will can, by itself, act as a restraint on bigness, too. The very process of creating such a document should draw a firm's attention to the places where it's taking on too much risk. And, if not, it would probably draw the attention of regulators, since the living wills will have to be filed with them on a regular basis. So the administration has proposed several ways to address the bigness issue. I just worry that they don't go far enough.