GRAY: Still too big to fail?

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ANALYSIS/OPINION:

During the height of the financial crisis, we heard a great deal about banks that were “too big to fail” — banks and other financial institutions that were so interconnected and so important to the stability and security of the financial system as a whole that their failure would be catastrophic. This theory led to the Troubled Asset Relief Program (the “bank bailout”) of 2008, and few — especially American taxpayers — want to repeat the experience.

Two years after the collapse of Fannie Mae and Freddie Mac and the banking crisis, where do we stand? In particular, does the financial services reform bill that recently passed the Senate actually address the problem of banks that are supposedly “too big to fail?”

Much of the debate in the Senate concerned a proposed $50 billion fund to assist large financial institutions in danger of failing.

While the fund would have been raised through assessments on institutions that could access the fund in times of crisis, opponents characterized this as a “bailout fund,” not least because, as the crisis of 2008 demonstrated, $50 billion is a pittance in addressing the capital requirements of large institutions.

Thus, Republicans rightly feared that taxpayers could once again be left on the hook. The provision was dropped in Senate debate to permit a vote on final passage. Instead, the Senate bill sets up a “Financial Stability Oversight Council,” whose job would be to identify and designate firms that would “pose a threat to the financial stability of the United States” if they encounter “material financial distress.”

Unpacking those words, this gives tremendous power to the agencies on that council to determine which firms deserve an implicit guarantee from the federal government — which in turn attracts investors and makes it easier to raise capital. That puts a federal hand on the scale and distorts competition in favor of the largest firms, many of which performed poorly in the run-up to the financial crisis.

In a crisis, would Congress really vote not to save a financial institution where the government believes that its failure would “pose a threat to the financial stability of the United States?” Of course not: No member wants to be tarred with the charge that “you destroyed the financial system.”

In theory, these firms are meant to be subject to greater regulation. However, identifying them in advance is a signal to investors that the government effectively believes they are too big or too important to fail. So investors feel they can have confidence in these firms, and the implicit government guarantee could encourage riskier behavior on the firms’ part, which in turn could bring us right back to another financial crisis if these firms’ riskier bets fail. That’s why, in opposing the bill, Sen. Russ Feingold, Wisconsin Democrat, stated that the bill “does not eliminate the risk to our economy posed by ‘too big to fail’ financial firms.”

And if that’s not bad enough, the designation of “too big to fail” doesn’t just apply to banks or bank holding companies but to any financial institution, just as non-bank AIG received a massive $150 billion bailout in 2008. As Peter Wallison of the American Enterprise Institute has written, “Designating large non-bank financial companies as too big to fail will be like creating Fannies and Freddies in every area of the economy.” American taxpayers simply can’t take that risk.

In short, ironic as it sounds, Wall Street needs to rediscover capitalism. In February, Kevin Warsh, a governor of the Federal Reserve System, wrote that “reforms must encourage robust competition. Smaller, dynamic companies, properly supervised, should be able to take market share. This is the way to level the playing field, far better than bullying or co-opting the largest, most interconnected institutions. But this won’t happen if policy divides those that are too big to fail from those that are not. It won’t happen if select incumbents have permanent funding advantages. And it won’t happen if policy preferences deter would-be competitors from taking on the big guys. [Instead,] it is up to financial institutions to demonstrate that they can fail without a need for extraordinary government support.”

Some financial institutions should never have been permitted to grow so large in the first place, particularly through mergers. Financial firms should be subject to regular antitrust rules, like other firms are. But in the meantime, at a minimum, we should ensure that some firms don’t receive implicit guarantees that they will not be allowed to fail. That’s a direct path to another financial crisis. When both Mr. Feingold and conservative commentators agree that the Senate bill will not resolve the “too big to fail” problem, we have a problem.

As Mr. Warsh wrote, “We will have done ourselves no favors if what is billed as ‘comprehensive regulatory reform’ over-promises and under-delivers.”

C. Boyden Gray served as U.S. ambassador to the European Union.

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