This is because the private cost of an institution’s failure underestimates its social cost. In other words, the externality implies that the appropriate risk calculus, taken from the perspective of a single institution, leads to excessive risk-taking from the perspective of society. The institution’s failure may be the unfortunate consequence of risks that, in the best case, were justified from the perspective of the institution itself. But it imposes additional costs on other financial and economic institutions and market participants. These extra costs were not taken into account even if the decision-making process was privately optimal. In what follows, let me discuss the appropriate recipe in the presence of an externality. Economic theory mainly suggests two measures: either restoring the appropriate incentives via a Pigovian tax8 or applying direct quantity regulation. Limiting the size of the bank One extreme solution to the TBTF problem falling within the second category of measures is to adopt the following precept: if an institution is too big to fail, then it is too big to exist.9 According to this view, the state should limit the size and scope of banks to levels where the TBTF externality does not materialise. Renouncing the benefits associated with scale and scope is the price to pay for this radical solution.10 Potentially even more costly is the fact that all benefits associated with size and scope that might be discovered in the future are also forgone!
There are five broad areas where reforms are urgently needed: first, reforms to improve education (and on-the-job training), boost research and development, enhance innovation and facilitate the diffusion of technological advances, so as to fully exploit the potential of an increasingly knowledge-based economy; second, reforms to increase competition in product and services markets; third, reforms in labour markets to increase flexibility and adaptability of the workforce; fourth, policies and institutions to create a more favourable business climate; and fifth, reforms to promote integration, enhance competition and foster innovation in European financial markets, with a special emphasis on venture capital. Time constraints do not permit me to go into detail on the multitude of the necessary reforms that I mentioned. What I would like to do, in line with the topic of my presentation, is to examine and explain how and why the necessary adjustments to market structures should be accompanied by fundamental adaptations of the pertinent economic institutions and changes in social attitudes (which are much  4  BIS Review 43/2007  harder to achieve), in order to improve the performance of the European economy.2 To this end, I will now concentrate my remarks on the labour market. In other recent papers, I have examined the role of the financial sector and of education in fostering Europe’s growth performance. The importance of institutions for the functioning of labour markets in Europe can hardly be overstated.