While the bills that have been passed in the Senate Banking Committee and on the House floor express the desire to see losses imposed on failing firms' creditors, they provide the government with wide-ranging discretion to designate financial firms as "systemically important" and use public funds in their resolution. But the resulting ambiguity about rescue policy is likely to just perpetuate the forces that brought us "too big to fail" to begin with. Improved regulations will contain the risks that brought us the last crisis, but new risk-taking arrangements inevitably will arise that by-pass existing regulatory restraints. If authorities allow creditor losses at one failing firm, then creditors are likely to pull away from other similar firms, fearing that authorities will forgo supporting them as well. Authorities will feel compelled to resolve uncertainty about implicit safety net support by expanding implied commitments. Subsequent regulations will rein in the new arrangements, the danger of which will by then be fully appreciated. But this just sets the stage for another cycle of by-pass, crisis, rescue and regulation.
A discretionary safety net, with no set boundaries, only feeds this cycle by giving market participants reason to believe that new, complex arrangements ultimately will be protected. It requires an ever-growing reach of financial regulation, and undermines the market discipline that helps align financial risk-taking with broader societal interests.