We face the same problem in the financial markets. If one bank looks likely to default and inflict damage on the entire financial system, the state will probably come to the rescue to prevent the situation from escalating – the bank is thus “too big to fail”.
This leads to inadequate risk premiums for claims on this bank; they distort competition and encourage players to enter into even riskier transactions. Yet systemic importance not only distorts the signals sent by market prices; it also, in a crisis, uproots the principle of liability. In rescuing a systemically important bank, at least part of the creditors’ losses are borne by the taxpayer.