Should Large Banks Be Allowed to Fail?

Abstract

The question of whether large banks should be allowed to fail brings us face to face with a conflict between two social goals. On the one hand, the goal of optimal resource allocation suggests that even very large banks, like other firms, should be allowed to fail. On the other hand, the stabilization goal suggests that, given the present institutional structure, failures of large banks should be prevented lest they lead to runs on other banks and to a significant reduction in the money stock. The solution suggested here for this conflict is small changes in the institutional structure.