69 Am. U. L. Rev. 967 (2020).

* Yale Law School.

** Faculty of Law, University of Oxford; European Corporate Governance Institute.

*** Sam Harris Professor of Corporate Law, Corporate Finance, and Securities Law, Yale Law School; European Corporate Governance Institute.

Regulators generally have tried to address the problems posed by the excessive risk-taking of Systemically Important Financial Institutions (SIFIs) by placing restrictions on the activities in which SIFIs engage. However, the complexity of these institutions makes such attempts necessarily imperfect. This Article proposes to address the problem at its very source, which is the incentives that SIFI owners have to push for excessive risk-taking by managers. Building on the traditional rule of “double liability,” we propose to modify the current (general) rule limiting the liability of SIFI shareholders to the amount of their initial investments in such companies. We propose replacing the extant limited liability regime with a new system that imposes additional liability over and above what SIFI shareholders already have invested in a preset amount that varies with a SIFI’s centrality in the financial network. Our liability regime has a number of advantages. First, by increasing shareholder exposure to downside risk, it discourages excessive risk-taking. At the same time, by placing a clearly defined ceiling on shareholders’ total liability exposure, it will not obliterate shareholders’ incentives to invest in the first place. Second, the liability to which shareholders are exposed is carefully tailored to the level of systemic risk that their institution creates. Thus, our rule induces shareholders to account for the negative externality SIFIs can impose without unduly stifling such financial institutions’ role within the financial system and in the wider economy. Third, as the amount of liability is clearly defined ex ante using the rigorous tools of network theory, our rule minimizes the influence of interest groups and the impact of idiosyncratic government decisions. Last, as markets know in advance the amount of liability to which shareholders are exposed, our rule favors the creation of a vibrant insurance and derivative market so that the risk of SIFIs defaults can be allocated to those who can better bear it.

Introduction

The default of a systemically important financial institution (SIFI) imposes significant negative externalities.1See, e.g., Fin. Crisis Inquiry Comm’n, The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States xviii–xix (2011) (arguing that one of the main causes of the 2007 financial crisis was SIFIs’ excessive risk-taking). Such a default inevitably propagates through the financial system with dramatic and fatal consequences for even the most prudently run businesses. It is understood that the risk of a national or global economic meltdown attributable to the failure of a systemically important financial institution justifies aggressive regulation as well as significant departure from ordinary and customary corporate governance norms for SIFIs.2See Fin. Stability Bd., Thematic Review on Corporate Governance 3 (2017), https://www.fsb.org/wp-content/uploads/Thematic-Review-on-Corporate-Governance.pdf [https://perma.cc/ZB6Q-87N4] (noting that jurisdictions routinely impose additional limitations to the activities of systemically important financial institutions); see also Basel Comm. on Banking Supervision, Corporate Governance Principles for Banks 6 (2015), https://www.bis.org/bcbs/publ/d328.pdf [https://perma.cc/L55G-9FTQ] (“SIFIs are expected to have in place the corporate governance structure and practices commensurate with their role in and potential impact on national and global financial stability.”). Perhaps the most telling manifestation of the public policy implications of being considered systemically important is the entrenched policy of governments around the world to bail out financially distressed SIFIs, despite the massive costs and perverse incentives associated with these bailouts. No one has devised a functional plan to enable governments credibly to commit to refrain from carrying out such bailouts.3For instance, the Dodd-Frank Act was introduced with the specific goal of putting an end to bailouts. Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Pub. L. No. 111-203, (2010) [hereinafter Dodd-Frank]; see Stephen J. Lubben & Arthur E. Jr. Wilmarth, Too Big and Unable to Fail, 69 Fla. L. Rev. 1205, 1205 (2017) (“The explicit goal of [the Dodd-Frank Act] is to enable a SIFI to fail . . . .”). However, the broad consensus is that the Dodd-Frank has failed to achieve this goal and it might even have backfired. See Christopher M. Bruner, Corporate Governance Reform in Post-Crisis Financial Firms: Two Fundamental Tensions, 60 Ariz. L. Rev. 959, 961 (2018) (“[T]he predominant bank holding companies remain so large and so complex that the legislative claim to have statutorily foreclosed future bailouts lacks credibility.”); Arthur E. Wilmarth, Jr., The Dodd-Frank Act: A Flawed and Inadequate Response to the Too-Big-To-Fail Problem, 89 Or. L. Rev. 951, 954 (2011) (discussing the “fundamental weaknesses in the financial regulatory systems”). See generally Roberta Romano, Dodd-Frank’s Regulatory Morass, Reg. Rev., Nov. 10, 2014, https://www.theregreview.org/2o14/11/10/romano-dodd-frank-consequences [https://perma.cc/38SD-7VH2] (reporting the widely held belief that the Dodd-Frank Act “has not resolved the ‘too-big-to-fail’ syndrome. In fact, it could well exacerbate it”).

It is well known that the near certainty that SIFIs will be bailed out creates acute moral hazard.4See, e.g., Heidi Mandanis Schooner & Michael W. Taylor, Global Bank Regulation: Principles and Policies 60 (2010);Jonathan R. Macey, Commercial Banking and Democracy: The Illusive Quest for Deregulation, 23 Yale J. Reg. 1 (2006); Saule T. Omarova, The “Too Big To Fail” Problem, 103 Minn. L. Rev. 2495, 2500 (2019) (“The well-known notion of ‘moral hazard’ captures the economic inefficiencies associated with this implicit subsidy: large firms shielded from the negative consequences of their risk-taking have an incentive to take greater risks than they otherwise would.”). Specifically, SIFI creditors, shareholders, directors, and managers, knowing that their firm will be bailed out if too many risky investments turn out badly, have incentives to take excessive risk5The term “excessive” is defined with respect to social welfare. See Steven L. Schwarcz & Aleaha Jones, Corporate Governance of SIFI Risk-Taking: An International Research Agenda, Cross-Border Bank Resol. (forthcoming 2017–18). “From a traditional corporate governance perspective, risk-taking would be considered excessive if it has a negative expected value to the firm and its investors—primarily the shareholders. . . . From a broader perspective, however, “excessive” risk-taking might also take into account societal consequences. One of us has argued that—at least for SIFIs—traditional corporate governance misaligns corporate interests and societal interests, and that any assessment of SIFI risk-taking should also take into account systemic externalities that could harm the public.” Id. and refrain from engaging in monitoring.6Adam J. Levitin, In Defense of Bailouts, 99 Geo. L.J. 435, 490 (2011) (“[I]f either or both creditors and shareholders of such a TBTF [too-big-to-fail] institution believe they will be made whole in a bailout—or not bear all the losses—they will have a reduced incentive to monitor the [TBTF] institution’s risk-taking, and they will not demand as great of a risk premium when they extend credit.”). But see Steven L Schwarcz, Too Big To Fool: Moral Hazard, Bailouts, and Corporate Responsibility, 102 Minn. L. Rev. 761, 765 (2017) (“There is no evidence, much less proof, that [too-big-to-fail] causes firms to engage in morally hazardous behavior. Most studies discussing such behavior merely assume it without actually offering evidence.”). To inhibit such excessive risk-taking, policymakers consistently pledge that there will be “no more tax-funded bailouts.”7See Transcript of President Barack Obama, Remarks by the President at Signing of Dodd-Frank Wall Street Reform and Consumer Protection Act (2010), https://obamawhitehouse.archives.gov/the-press-office/remarks-president-signing-dodd-frank-wall-street-reform-and-consumer-protection-act [https://perma.cc/2QXV-4CRL]. President Obama stated: “[B]ecause of this law, the American people will never again be asked to foot the bill for Wall Street’s mistakes. There will be no more tax-funded bailouts-period. If a large financial institution should ever fail, this reform gives us the ability to wind it down without endangering the broader economy. And there will be new rules to make clear that no firm is somehow protected because it is ‘too big to fail.'”Id. But such pledges are unconvincing because, unlike Ulysses, regulators and politicians cannot credibly tie themselves to the mast.8Levitin, supra note 6, at 439 (footnote omitted). Professor Levitin argues: “Law is an insufficient commitment device for avoiding bailouts altogether. It is impossible to produce binding commitment to a preset resolution process, irrespective of the results. The financial Ulysses cannot be bound to the mast. Although we may want Ulysses to be bound to the mast when the sailing is smooth to avoid the sirens’ call of politically directed state intervention in the market, the situation changes once the ship has hit the rocks. Once the ship is foundering, we do not want Ulysses to be bound to the mast, lest go down [sic] with the ship and drown. Instead, we want to be sure his hands are free to bail. The question then, is not whether to have bailouts but how bailouts should be structured.” Id. Bailouts are therefore a fact of life.9See Peter Conti-Brown, Elective Shareholder Liability, 64 Stan. L. Rev. 409, 423–25 (2012) (discussing the impossibility of “Never Again” for bailouts).

Regulators generally have tried to mitigate SIFIs’ proclivity to engage in excessive risk-taking by imposing strict capital requirements and placing restrictions on the activities in which SIFIs can engage.10See, e.g., Alexander W. Salter, Vipin Veetil & Lawrence H. White, Extended Shareholder Liability as a Means to Constrain Moral Hazard in Insured Banks, 63 Q. Rev. Econ. & Fin. 153, 153 (2017). Yet, the high costs and sheer complexity of these regulations make such attempts necessarily imperfect.11Thomas Hoenig, the former vice chairman of the FDIC and the former President of the Federal Reserve Bank of Kansas City, noted that “[t]he problem is not that banks take risk, but that some are too complex for anyone to assess and control that risk.” Thomas Hoenig, Why the Sign Must Say: No UBS in the USA, Fin. Times, June 16, 2011, at 11. This Article proposes an important new addition to these standard regulatory approaches by addressing the problem at its very source, which is the market-based incentives that SIFI owners have to encourage and incentivize excessive risk-taking by managers. Our proposal is to modify the current practice of limiting the liability of SIFI shareholders to the amount of their investment in such companies.

We propose replacing the extant limited liability regime with a new system that imposes a fixed and stable amount of potential additional liability, over and above what SIFI shareholders already have invested, in case the SIFI is resolved or bailed out. By increasing shareholder exposure to downside risk, our proposal strongly discourages excessive risk-taking. At the same time, by placing a fixed ceiling on shareholders’ total liability exposure, it will not eradicate shareholders’ incentives to invest in the first place.12Bainbridge and Henderson note that “there is considerable truth to the widely shared view that limited liability was, and remains, essential to attracting the enormous amount of investment capital necessary for industrial corporations to arise and flourish.” See Stephen M. Bainbridge & M. Todd Henderson, Limited Liability: A Legal and Economic Analysis 50–51 (2016). In Section II.B, we argue that unlimited liability would lead to overdeterrence and shrink the size of the financial sector beyond what is optimal. The advantage of our approach is that, by realigning shareholders’ incentives to reduce SIFI risk-taking to more societally acceptable levels, it provides a measured and proportionate complement to existing, highly imperfect regulatory initiatives to reduce excessive risk-taking. Thus, our approach is unique in that it will create an operating environment in which bankers with properly aligned incentives will voluntarily engage in societally beneficial self-discipline and avoid excessive risk-taking in the first place.

The legal regime of extended liability that we propose for SIFIs is different from both unlimited and “classic” limited liability systems. Under the former, which is traditionally the rule for general partners in partnerships, partners are liable for the partnership’s unsatisfied debts, whether deriving from contractual obligations or torts, with no cap on the amount of the liability.13See, e.g., Robert C. Clark, Corporate Law 6–7 (1986) (describing the liability regime for general partners). In the classic limited liability system, which has been the rule for corporations in the last couple of centuries, shareholders are not liable for any of the unpaid corporate debts.14Id. at 7. Hence, their loss is limited to their investment in the company if it goes bankrupt.15Id. Extended liability is located in between these two extremes because shareholders stand to lose more than their investment in the company, but their downside exposure is still capped at a preset amount.

The main claim of this Article is that, for SIFIs, a carefully crafted extended liability regime is superior to both unlimited and traditional limited liability. To be clear, we do not argue that an extended liability rule can induce shareholders to internalize all the possible externalities caused by the distress of a SIFI. As we argue in Section II.B, this result is both impossible to achieve under any liability rule and undesirable. Instead, the more modest goal of our rule is neutralizing the moral hazard created by the expectation of SIFI bailouts.

Extended liability has a long and illustrious tradition in the United States. For roughly three quarters of a century, shareholders of banks faced a rule of “double liability,” which made them liable for more than they had invested in the bank.16For a discussion of double liability, see Jonathan R. Macey & Geoffrey P. Miller, Double Liability of Bank Shareholders: History and Implications, 27 Wake Forest L. Rev. 31, 31 (1992). Scholars, including one of us with Geoffrey Miller, have argued that it is important to investigate “whether double liability—or some variant on the idea—offers promise for coping with contemporary problems in the banking industry.”17Id. at 62. We return to this question showing that the current features of the financial system (namely, the presence of capital ratios for financial institutions, the dominance of institutional share ownership, and the availability of well-developed insurance and derivatives markets) create the perfect conditions for implementing a special form of extended liability. Against this background, the argument advanced in this Article is then articulated in four steps. First, limited liability is inadequate for SIFIs. Second, due to the specific features of SIFIs, it is possible to avoid the theoretical and practical shortcomings that are usually associated with extending shareholder liability. Third, unlimited shareholder liability for SIFIs would be inefficient. Fourth, a carefully designed, “network-sensitive” rule of extended liability would outperform both limited and unlimited liability.

The structure of the Article is as follows. Part I explains why it is important to ensure that systemically important financial institutions do not engage in excessive risk-taking. Moreover, this part sketches the proposals that have been advanced by the literature to increase shareholders’ liability, and hence reduce their risk propensity. Part II explains why the traditional limited liability rule and a regime of unlimited liability for shareholders are both undesirable for SIFIs. Part III is the core of the Article and describes in detail the liability rule that we propose. Part IV tries to anticipate the effect that our liability rule would have on equity markets and SIFI ownership. Part V shows how traditional objections to unlimited shareholder liability either do not apply to our proposed rule or can be easily addressed and outlines how shareholders of SIFIs transitioning to the proposed regime could be compensated for the losses it imposes on them. Part VI briefly concludes by summarizing the main findings of the Article.

I.   The Challenge of Taming SIFIs

To begin our analysis, we start by explaining why policymakers still face a serious challenge in providing for an effective regulatory framework for tackling SIFIs and their tendency to engage in excessive risk-taking. Next, we briefly review previous proposals to dispense with shareholder limited liability. We cover both general recommendations in that direction, namely Henry Hansmann and Reinier Kraakman’s proposal to make shareholders liable towards tort creditors,18Henry Hansmann & Reinier Kraakman, Toward Unlimited Shareholder Liability for Corporate Torts, 100 Yale L.J. 1879, 1880 (1990). and the more recent, post-crisis suggestions to extend shareholder liability with respect to (some) financial institutions, explaining why each of them would be inadequate as a tool to prevent SIFIs’ excessive risk-taking. We also discuss the double shareholder liability regime which applied to banks for a considerable period of U.S. history.

A.   SIFIs and Interconnections Within the Financial Network

The recent financial crisis has been a stunning reminder of the fragility of the financial system. As its various parts are increasingly intertwined, large shocks can quickly propagate throughout the financial system and to the real economy with catastrophic consequences.19See John C. Coffee, Jr., Systemic Risk After Dodd-Frank: Contingent Capital and the Need for Regulatory Strategies Beyond Oversight, 111 Colum. L. Rev. 795, 797, 847 (2011) (defining systemic risk as “the risk that a localized economic shock can have worldwide repercussions because of the interconnections between financial institutions”); Steven L. Schwarcz, Systemic Risk, 97 Geo. L.J. 193, 199 (2008). National and supranational policymakers reacted by tightening up the regulatory framework with the aim of minimizing the risk of future financial crises.20See, e.g., Daniel K. Tarullo, Financial Regulation: Still Unsettled a Decade After the Crisis, 33 J. Econ. Persp. 61, 64–70 (2019). The main targets of these regulations have been so-called systemically important financial institutions (SIFIs), that is, banks and other financial institutions—the failure of which, due to their size and interconnectedness, can bring down the entire financial system.21In fact, the Dodd-Frank Act states, in its preamble, that one of its primary objectives is ending the too-big-to-fail problem. See Dodd-Frank, Pub. L. No. 111-203, 124 Stat. 1376 (codified at 12 U.S.C. § 5301 (2012)) (stating that the Dodd-Frank intends to “to end ‘too big to fail,’ [and] to protect the American taxpayer by ending bailouts”).

Describing the new regulatory framework lies outside the scope of this Article,22For an excellent introduction, see generally David Skeel, The New Financial Deal: Understanding the Dodd-Frank Act and Its (Unintended) Consequences (2011). but two facts are worth mentioning. First, policymakers have significantly expanded the portfolio of regulatory tools to preserve financial stability. Before the crisis, most of the regulations aimed at ensuring the solvency of the individual financial institutions without paying attention to the interconnections among them.23See Samuel G. Hanson et al., A Macroprudential Approach to Financial Regulation, 25 J. Econ. Persp. 3, 3 (2011) (describing a microprudential approach as “one in which regulation is . . . aimed at preventing the costly failure of individual financial institutions”). See generally Michael S. Barr et al., Financial Regulation: Law and Policy 310 (2d ed. 2018) (arguing that one of the main problems of the capital requirements that were imposed before the crisis was that they did not account for the interconnectedness of financial institutions). Departing from this “microprudential” approach, policymakers have now introduced a new family of “macroprudential” policies that attempt to protect the financial system as a whole.24See Kristin N. Johnson, Macroprudential Regulation: A Sustainable Approach to Regulating Financial Markets, 2013 U.Ill. L. Rev. 881, 881 (2013) (arguing that “the culture of financial institutions may lead [a] Board to govern these businesses less effectively than boards in non-financial sectors”). See generally Ben Bernanke, Implementing a Macroprudential Approach to Supervision and Regulation, Remarks at the 47th Annual Conference on Bank Structure and Competition, (May 5, 2011), in https://www.federalreserve.gov/newsevents/speech/bernanke20110505a.htm [https://perma.cc/P58X-KWCS], at 1 (explaining that the post-crisis legislation requires “the Federal Reserve and other financial regulatory agencies adopt a so-called macroprudential approach . . . [that] supplements traditional supervision and regulation of individual firms or markets with explicit consideration of threats to the stability of the financial system as a whole”). These new policies have significantly complicated the regulatory landscape25As noted by Daniel Tarullo, a former member of the Board of Governors of the United States Federal Reserve Board, the Dodd-Frank Act alone “called for literally hundreds of new regulations, an approach that entailed protracted and often complicated rulemakings.” Tarullo, supra note 20, at 70. and yet have not eliminated the risk of a systemic crisis. Regardless of how carefully they are devised, ex ante regulations—be they micro or macro—cannot eliminate systemic risk: “[f]ailure is a fact of economic life.”26Levitin, supra note 6, at 478 (crises are bound to occur in complex, tightly-coupled systems, such as the financial system); see Iman Anabtawi & Steven L. Schwarcz, Regulating Ex Post: How Law Can Address the Inevitability of Financial Failure, 92 Tex. L. Rev. 75, 102 (2013); see also Yair Listokin, Law and Macroeconomics 6 (2019) (“[E]ven the best financial regulation is doomed to periodic failure.”). Moreover, regulators suffer from a chronic lack of information that impairs their ability to produce effective policies.27See, e.g., John Armour et al., Principles of Financial Regulation 579–80 (2016). For instance, leading financial economists have suggested that the capital requirements for SIFIs should be greatly increased.28See generally Anat Admati & Martin Hellwig, The Bankers’ New Clothes: What’s Wrong with Banking and What to Do About It 79–166 (2013) (discussing the social benefits of higher capital requirements). Capital reserves constitute a fundamental buffer that allow banks to be more resilient during times of stress, thereby increasing the stability of the financial system.29Id. at 6 (“Capital regulation requires that a sufficient fraction of a bank’s investments or assets be funded with unborrowed money. . . . Having a minimal ratio of unborrowed funds relative to total assets is a way to limit the share of assets that is funded by borrowing. Because unborrowed funds are obtained without any promise to make specific payments at particular times, having more equity enhances the bank’s ability to absorb losses on its assets.”); see also Tarullo, supra note 20, at 65 (noting that capital requirements “are . . . recognized as an especially supple prudential tool, insofar as they are available to absorb losses from sources both anticipated and unanticipated by bankers and regulators”). For an overview of capital bank regulation, see Richard Scott Carnell et al., The Law of Financial Institutions 215–69 (5th ed. 2013). The higher the capital reserves, the greater the losses banks are able to absorb. This is especially true for tier one capital, which includes only capital elements of the highest quality.30More precisely, tier one capital is divided in Common Equity tier one capital (CET1) and Additional tier one capital. The former is composed of “qualifying common stock and related surplus net of treasury stock; retained earnings; certain accumulated other comprehensive income (AOCI) elements if the institution does not make an AOCI opt-out election . . . plus or minus regulatory deductions or adjustments as appropriate; and qualifying common equity tier 1 minority interests. . . . [Q]ualifying noncumulative perpetual preferred stock, bank-issued Small Business Lending Fund and Troubled Asset Relief Program instruments that previously qualified for tier 1 capital, and qualifying tier 1 minority interests, less certain investments in other unconsolidated financial institutions’ instruments that would otherwise qualify as additional tier 1 capital.” Federal Deposit Insurance Corporation (FDIC), Risk Management Manual of Examination Policies, § 2.1-3 (2015) https://www.fdic.gov/regulations/safety/manual/section2-1.pdf [https://perma.cc/7JLE-WHPK]. But identifying the optimal capital requirement for each SIFI requires a level of information that regulators simply cannot have. Hence, capital requirements imposed by regulators are likely to be either too lax, in which case they fail to ensure the stability of the financial system, or too strict, in which case they impose unnecessary constraints on SIFIs’ activities.31See Harry DeAngelo & René M. Stulz, Liquid-Claim Production, Risk Management, and Bank Capital Structure: Why High Leverage Is Optimal for Banks, 16 J. Fin. Econ. 219, 231–33 (2015) (discussing why exceedingly high capital requirements can impose substantial costs). Our liability rule is an attempt to bypass these informational problems by improving the incentives of shareholders on the one hand and by enlisting markets in the monitoring of SIFIs’ solvency on the other.

Second, regulators have attempted to mitigate the moral hazard problem created by bailouts. The financial crisis has reminded SIFIs once more that they are just too big to fail, and hence regulators are forced to intervene if a SIFI is in distress.32See Gary H. Stern & Ron J. Feldman, Too Big to Fail: The Hazards of Bank Bailouts 23–28 (2004) (discussing the too-big-to-fail problem). In this vein, anticipating that governments will bail them out in case of need, SIFIs have incentives to engage in excessive risk-taking, while their creditors have weaker incentives to monitor them.33See, e.g., Levitin, supra note 6, at 490 (“[I]f either or both creditors and shareholders of such a TBTF [too-big-to-fail] institution believe they will be made whole in a bailout—or not bear all the losses—they will have a reduced incentive to monitor the TBTF institution’s risk-taking, and they will not demand as great of a risk premium when they extend credit.”). To prevent this moral hazard problem, regulators have attempted to tie their own hands by introducing mechanisms to prevent future bailouts. The most important of these mechanisms are the Orderly Liquidation provisions in Title II of the Dodd-Frank Act,34Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010) (codified at 12 U.S.C. § 5301 (2012)). which aim to facilitate the resolution of large, complex financial institutions by providing for a new bankruptcy procedure to be used for bank holding companies and their subsidiaries as an alternative to the Bankruptcy Code.35See 12 U.S.C. §§ 5381–394 (2012). A failing institution is placed in receivership under the control of the Federal Deposit Insurance Corporation (FDIC).36Id. § 5384(b). The FDIC, under the Orderly Liquidation Authority (OLA), has the power to act swiftly in order to find a new owner for the “good” parts of the failing institution, with access to government money to finance the operations of a “bridge bank” until the buyer for the good parts has been found.37Id. § 5390(h) (describing the functioning and the purpose of bridge financial companies). That should ensure continuity of operations and therefore avoid the negative effects on other financial institutions of a SIFI bankruptcy.

Yet, serious doubts have been raised as to whether the OLA would be sufficient to resolve a major SIFI, such as Bank of America, which is not only orders of magnitude larger than any of the commercial banks the FDIC usually deals with, but also active across different businesses and jurisdictions.38See Stephen J. Lubben, Resolution, Orderly and Otherwise: B of A in OLA, 81 U. Cin. L. Rev. 485, 513–16 (2012). The OLA procedure also raises thorny constitutional problems. See Thomas W. Merrill & Margaret L. Merrill, Dodd-Frank Orderly Liquidation Authority: Too Big for the Constitution?, 163 U. Pa. L. Rev. 165 (2014) (evaluating the constitutional challenges and issues that Dodd-Frank triggers). Even more doubtful is whether the OLA would work in the event of a systemic crisis in which the survival of not one, but many, if not all, of the existing SIFIs was at stake.39Lubben & Wilmarth, supra note 3, at 1205 (arguing that the resolution procedures introduced with the Dodd-Frank Act are “unlikely to work as intended during a future global crisis that involves multiple failing SIFIs operating thousands of subsidiaries across dozens of national boundaries”). In such a case, it will be virtually impossible to find a buyer for the good parts of the failing SIFIs. Moreover, SIFIs’ operating companies may also face illiquidity, if not insolvency problems, due to their credit or balance sheet interconnections, which may make a government recapitalization the only viable solution.40See Stephen J. Lubben, OLA After Single Point of Entry: Has Anything Changed?, (Seton Hall Pub. Law Res. Paper No. 2353035, 2014), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2353035.

Ultimately, committing not to bail out SIFIs is impossible. The Darwinian proclivity for survival that characterizes political behavior in democracies leads politicians and policymakers to offer bailouts no matter how tough the ex ante rules on using taxpayers’ money to prop up banks. The immediate political benefits of a bailout, namely, the avoidance of the doomsday scenario of a financial and economic meltdown, are bound to appear superior to navigating the political consequences of such an outcome.41See, e.g., Oliver Hart & Luigi Zingales, A New Capital Regulation for Large Financial Institutions, 13 Am. L. & Econ. Rev. 453, 482 (2011); Tarullo, supra note 20, at 69. On the special insolvency mechanism, Tarullo notes that “the risks of an untested resolution regime are real, and officials may not be willing to take even a modest chance that a systemically important firm placed into resolution would implode.” Id. As noted by the Financial Crisis Inquiry Commission, “if you bail out AIG and you’re wrong, you will have wasted taxpayer money and provoked public outrage. If you don’t bail out AIG and you’re wrong, the whole financial system collapses.”42Fin. Crisis Inquiry Comm’n, supra note 1, at 433. In sum, “[b]ailouts are an inevitable feature of modern economies, in which the interconnectedness of firms means that the entire economy bears the risk of an individual firm’s failure.”43Levitin, supra note 6, at 439; see also Conti-Brown, supra note 9, at 424. Therefore, realistically, policymakers should attempt to minimize the moral hazard created by bailouts instead of hoping to convince the markets that bailouts will not happen in the future. This is exactly what our extended liability rule attempts to do.

The fact that firms are tightly interconnected has another fundamental implication that economists have fully appreciated, although legal scholars have sometimes overlooked: the structure of the financial sector, and in particular the pattern of connections among financial institutions, has a fundamental impact on the stability of the financial system.44See, e.g., Daron Acemoglu et al., Systemic Risk and Stability in Financial Networks, 105 Am. Econ. Rev. 564, 564 (2015) (“Since the global financial crisis of 2008, the view that the architecture of the financial system plays a central role in shaping systemic risk has become conventional wisdom.”). In order to study these inter-bank connections and the network they form, scholars of different fields have relied on network theory.45Despite the enormous influence of network theory on many fields, legal scholars have generally overlooked its insights, with some exceptions. See Alan Schwartz & Robert E. Scott, Third-Party Beneficiaries and Contractual Networks, 7 J. Legal Analysis 325, 325 (2015); Luca Enriques & Alessandro Romano, Institutional Investor Voting Behavior: A Network Theory Perspective, 2019 U. Ill. L. Rev. 223 (2019); Alessandro Romano, Horizontal Shareholding: The End of Markets and the Rise of Networks (2019), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3255948. For an introduction to network theory, see Sanjeev Goyal, Connections: An Introduction to the Economics of Networks (2009); Mark Newman, Networks (2d ed. 2018). Within the framework of network theory, the building blocks of a network are its nodes and the connections among them. Thus, if one models the financial sector as a network, the banks and the other financial intermediaries represent the nodes, while the financial flows among them represent the connections.46See, e.g., Marco Galbiati, Danilo Delpini & Stefano Battiston, The Power to Control, 9 Nature Physics 126, 126 (2013). One important finding of this strand of literature is that, besides size, the position and the level of a financial institution’s interconnections also determine its ability to impose negative externalities on the financial sector and the economy in general.47Robin L. Lumsdaine et al., The Intrafirm Complexity of Systemically Important Financial Institutions 1 (2016), https://papers.ssrn.com/sol3/papers.cfm?abstract _id=2604166 (“While size-based thresholds are appealing from a regulatory perspective . . . , they are overly simplistic in the presumption that risk can be evaluated via a single value.”); Serafin Martinez-Jaramillo et al., An Empirical Study of the Mexican Banking System’s Network and Its Implications for Systemic Risk, 40 J. Econ. Dynamics & Control 242, 256 (2014) (centrality measures “go beyond size and, in some cases, are not correlated or even negatively correlated with the size of an institution”). See Steven L. Schwarcz, Derivatives and Collateral: Balancing Remedies and Systemic Risk, 2015 U. Ill. L. Rev. 699, 706–11, 713–15 (2015) (discussing interconnectedness and substitutability of an institution as determinants of the systemic risk it poses). In fact, policymakers and economists alike have acknowledged that some institutions are too interconnected to fail.48See, e.g., Sheri Markose, Simone Giansante & Ali Rais Shaghaghi, ‘Too Interconnected to Fail’ Financial Network of US CDS Market: Topological Fragility and Systemic Risk, 83 J. Econ. Behav. & Org. 627, 627 (2012); Ben S. Bernanke, Chairman, Bd. of Governors of the Fed. Res. Sys., Statement Before the Financial Crisis Inquiry Commission 20 (Sept. 2, 2010), https://www.federalreserve.gov/newsevents/testimony/bernanke20100902a.pdf [https://perma.cc/ZNF8-DHJT] (arguing that the status of too-big-to-fail depends also on the complexity, the interconnectedness, and the critical functions that a financial institution performs). See generally Michael Gofman, Efficiency and Stability of a Financial Architecture with Too-Interconnected-To-Fail Institutions, 124 J. Fin. Econ. 113 (2017). For instance, the Federal Reserve rescued Bear Stearns, a relatively small financial institution due to its interconnections with other key financial actors.