In the secondnarrative, the world’s largest banks remain too big to manage and have strongincentives to engage in precisely the kind of excessive risk-taking that canbring down economies. Last year’s “London Whale” trading losses at JPMorganChase are a case in point. And, according to this narrative’s advocates, almostall big banks display symptoms of chronic mismanagement.

While the debate overmegabanks sometimes sounds technical, in fact it is quite simple. Ask thisquestion: If a humongous financial institution gets into trouble, is this a bigdeal for economic growth, unemployment, and the like? Or, more bluntly, could Citigroup or asimilar-size European firm get into trouble and stumble again toward failure without attractingsome form of government and central bank support (whether transparent orsomewhat disguised)?

The US took a step inthe right direction with Title II of the Dodd-Frankreform legislation in 2010, which strengthened the resolution powers of theFederal Deposit Insurance Corporation.  And the FDIC has developed someplausible plans specifically for dealing with domestic financial firms. (Iserve on the FDIC’s Systemic Resolution Advisory Committee; all views statedhere are my own.)

But a great mythlurks at the heart of the financial industry’s argument that all is well. TheFDIC’s resolution powers will not work for large, complex cross-borderfinancial enterprises.  The reason is simple: US law can create aresolution authority that works only within national boundaries. Addressingpotential failure at a firm like Citigroup would require a cross-borderagreement between governments and all responsible agencies.

On the fringes of theInternational Monetary Fund’s just-completed spring meetingsin Washington, DC, I had the opportunity to talk with senior officials andtheir advisers from various countries, including from Europe. I asked all ofthem the same question: When will we have a binding framework for cross-borderresolution?

The answers typicallyranged from “not in our lifetimes” to “never.” Again, the reason is simple:countries do not want to compromise their sovereignty or tie their hands in anyway. Governments want the ability to decide how best to protect their countries’perceived national interests when a crisis strikes. No one is willing to sign atreaty or otherwise pre-commit in a binding way (least of all a majority of theUS Senate, which must ratify such a treaty).

As Bill Dudley, thepresident of the New York Federal Reserve Bank, put it recently, using the delicate language of centralbankers, “The impediments to an orderly cross-border resolution still need tobe fully identified and dismantled. This is necessary to eliminate theso-called ‘too big to fail’ problem.”

Translation: Orderlyresolution of global megabanks is an illusion. As long as we allow cross-borderbanks at or close to their current scale, our political leaders will be unableto tolerate their failure. And, because these large financial institutions areby any meaningful definition “too big to fail,” they can borrow more cheaplythan would otherwise be the case. Worse, they have both motive and opportunityto grow even larger.

This form ofgovernment support amounts to a large implicit subsidy for big banks. It is abizarre form of subsidy, to be sure, but that does not make it any lessdamaging to the public interest. On the contrary, because implicit governmentsupport for “too big to fail” banks rises with the amount of risk that theyassume, this support may be among the most dangerous subsidies that the worldhas ever seen. After all, more debt (relative to equity) means a higher payoffwhen things go well. And, when things go badly, it becomes the taxpayers’problem (or the problem of some foreign government and their taxpayers).

What other part ofthe corporate world has the ability to drive the global economy into recession,as banks did in the fall of 2008? And who else has an incentive to maximize theamount of debt that they issue?

What the twonarratives about financial reform have in common is that neither has a happyending. Either we put a meaningful cap on the size of our largest financialfirms, or we must brace ourselves for the debt-fueled economic explosion tocome.