03/07/2013 12:25 pm ET Updated May 07, 2013

'Too Big to Jail' Is a Grave Threat to Financial Stability and Economic Recovery

The big news yesterday in financial services regulation is Attorney General Eric Holder's stunning statement before the Senate Judiciary Committee that some banks may be too big to prosecute:

I am concerned that the size of some of these institutions becomes so large that it does become difficult for us to prosecute them when we are hit with indications that if you do prosecute, if you do bring a criminal charge, it will have a negative impact on the national economy, perhaps even the world economy, and I think that is a function of the fact that some of these institutions have become too large.

Here's the video.

Too-big-to-fail just got much more frightening.

A little over a year ago, Micah Hauptman and I petitioned the Financial Stability Oversight Council to break up Bank of America because it poses a "grave threat" to the financial stability of the United States. The same logic applies to other large banks, as suggested in this letter signed by advocacy groups, professors, and other experts. Our petition argued that regulators must exercise their Dodd-frank Act authority to break up "grave threat" banks well before one of them is on the brink of collapse. Otherwise, that authority will likely be useless. Same goes for Dodd-Frank's orderly liquidation authority, which is intended to avoid bailouts. In short, the solution too-big-to-fail is to transform an institution like Bank of America into units that are smaller, less interconnected, more manageable, and more stable -- and Dodd-Frank gives regulators the authority to do just that. It arguably requires them to use it, or else significant portions of Dodd-Frank will become nullities. As it turns out, the government hasn't just ignored our petition. It has secretly extended new bailouts to Bank of America, releasing the bank from billions of dollars in fraud claims.

Our argument regarding the "grave threat" to financial stability centered on Bank of America's precarious financial condition. But a U.S. policy that big banks and their executives are largely immune from criminal prosecution will give "grave threat" a whole new dimension. The mere existence of too-big-to-jail institutions likely poses a grave threat to the economy regardless of their present financial condition. Executives of the largest banks will have strong incentives -- in fact, they will face market pressure -- to engage in reckless, even disastrous, criminal conduct, so long as it benefits them in the short term. Honest banks will be out-competed by those that press these unfair advantages to the fullest.

Setting aside the incentives of individual large banks, the rule of law itself is one of the most important conditions for a healthy economy. Too-big-to-jail cuts directly against the rule of law. How is the economy supposed to function if we can't trust the institutions that hold deposits, process payments, underwrite stock offerings, and so on?

The government needs to take this seriously. It ought to take immediate steps to demonstrate that Holder's comment does not reflect U.S. policy, and words alone won't suffice, given so many previous statements and actions to the contrary. I have no illusions that this will happen, but we're in for a rough ride without it.