On Wednesday, FRB Governor Dan Tarullo yet again shook up his big-bank charges, this time outlining a new approach to defining “financial stability” that pretty much said that no big bank will ever have any. From this, he concludes, the Fed should hammer the large financial firms through capital, consolidation and size limits to ensure that none is ever too big to fail and, thus, do harm to bystanders – negative externalities in economist-speak. Still more rules along Mr. Tarullo’s lines might make sense if big banks were still too big to fail, as Mr. Tarullo clearly believes them to be. But, as a study we will shortly release makes clear, they aren’t. In my view, regulators should put their formidable firepower not in thinking up new things to do to banks just in case they pose negative externalities, but rather into finalizing a regime that makes darn sure they can’t and don’t.

U.S. law stipulates that the federal government can never again rescue a SIFI and the FDIC is building this barrier to bail-out into a functional resolution regime. Is the law perfect – what is? But, if imperfect, it’s clear: the only way a SIFI can get bailed out next time around is if Congress loses its nerve and repeals the orderly liquidation authority (OLA) constructed in Dodd-Frank with an express statutory prohibition on big-bank rescue. To judge OLA now by what Congress might do later is not only unfair, but also counter-productive. The more markets believe in big-bank rescue, the more surprised they will be when one doesn’t materialize under stress and, then, the worse the market and macroeconomic consequences. The result of discrediting OLA instead of finishing its construction is to leave financial markets with the worst of two worlds: moral hazard as before in a market still without any safety net to protect the innocent.

What does Mr. Tarullo say about SIFI resolution? First, he notes that, “The financial stability approach begins from the fact that there would be very large negative externalities associated with the disorderly failure of any systemically important financial institution, distinct from the costs incurred by the firm and its stakeholders.” Why OLA would be “disorderly” is never described except that Mr. Tarullo goes on to say that, “…even if implemented successfully and as intended, the new Title II would be most effective in containing moral hazard by ensuring that shareholders and management of the failed firm bear heavy costs. It would not necessarily prevent all the damage to the financial system and the broader economy that would attend failure of a large financial firm.”

Why not? This he doesn’t say, but it’s the critical question. I’ll try to answer it first by agreeing that OLA has a ways to go, a point with which the FDIC concurs and on which lots of hard work is well under way. But, does the fact that OLA is incomplete mean that it’s doomed? I think not, but if Mr. Tarullo disagrees, then he should recommend repeal of Title II in concert with his new regulations.

Importantly, Title I of Dodd-Frank and lots else in the law must also be taken into account when asserting that SIFIs are still prone to disorderly failure with tragic consequences. If big banks build out disciplined living wills and, if they don’t, regulators then sanction the firm, disorderly resolution is made far less likely due to solvency risk at one big firm or from too many SIFIs betting too much on one counterparty. If solvency risk is dramatically reduced by new capital – a point Mr. Tarullo accepts – then this risk drops dramatically. Liquidity risk is also being markedly reduced through new rules and, if this fails, the FRB can still step in with needed central-bank support – no bail-out here, but needed market stabilization Mr. Tarullo again supports. To boot, big banks are being subjected to lots of other rules – prudential standards, vital governance mandates, changed derivatives procedures, Volcker, et. al. – again all designed to prevent systemic risk. Shadow banks remain too far out of this new regulatory framework, but penalizing big banks won’t do anything for the shadows but darken them.  In short, the best way to govern big banks is to let the market do it by penalizing them heavily in advance of stress and, then, dooming the firm and its credulous counterparties if the SIFI fails. The best way to protect the financial system from Mr. Tarullo’s negative externalities is, as I have argued in the past, to protect the innocent and punish the guilty. Neither of these goals is accomplished by regulating big banks coming and going. Indeed, doing so punishes the innocent because U.S. banks will become hidebound, meaning that the soon-to-be guilty lurking in the shadows taking on risk banks eschew will yet again go scot-free.