- The Washington Times - Thursday, March 3, 2011

The finance ministers of the Group of 20, meeting in Paris last weekend, signaled their intention to address the issue of too-big-to-fail (TBTF) financial firms at their next meeting. The Paris communique calls for “higher loss absorbency measures” and “levies” on systemically important financial institutions.

It is well-documented that TBTF firms enjoy a substantial taxpayer subsidy in the form of lower borrowing costs. The markets recognize that countries cannot allow their largest financial institutions to fail. In the United States, for example, the five largest banks control more than 50 percent of banking assets. The economic impact of their failure would be devastating.

As a result of this subsidy, the TBTF firms have morphed into versions of Fannie Mae and Freddie Mac, absent the public mission those twins hide behind. Privatize the gains and socialize the losses - sound familiar?

The deeply flawed Dodd-Frank Wall Street reform act resigns us to a world where the TBTF firms become even larger and more threatening. Rather than root out the problem, the new law attempts to address it through extensive government involvement in micromanaging those firms and selecting winners and losers. Nothing in economic history inspires confidence that government can successfully manage private-sector firms.

There is a bold, simple and workable solution that all can embrace. This plan balances the two pillars of democratic capitalism - regulation and market discipline. It places the ultimate fate of TBTF firms where it belongs, in the hands of their shareholders, while protecting the financial system and taxpayers from future TBTF meltdowns.

First, identify the handful of TBTF institutions. Largely, the regulators and the credit-rating agencies already have done this (Goldman Sachs, Citigroup, Bank of America, JPMorgan Chase, UBS, Barclays, Deutsche Bank, etc.).

Second, require each TBTF firm to establish a separate reserve account on its balance sheet funded by the annual taxpayer subsidy it enjoys as a result of its privileged status and lower funding costs. (We call it a “subsidy reserve.”) Treated as capital for liquidation purposes but not for regulatory purposes, the subsidy reserve is calculated based on the “support” versus “stand-alone” ratings currently assigned by credit-rating agencies. However calculated, it’s a significant amount.

Third, require that the subsidy reserve, including the earnings on it, accumulate indefinitely on the TBTF firms’ balance sheets.

Fourth, provide that the subsidy reserve can be transferred to shareholders or others onlyin the form of spinoffs or sales of companies or divisions; it cannot be paid out in the form of dividends or the buyback of shares. In other words, the only way the value of the subsidy reserve can be unlocked is through downsizing the firm. In a short time, the TBTF firms will be carrying very large reserves, which will be available for use only in the event of a firm’s failure.

The accumulation of reserves, combined with higher capital and liquidity requirements imposed by regulators, will lead to shareholder demands that the reserves be used more efficiently. Managements and boards of directors faced with those demands will have two choices:

They can continue business as usual, in which case, the subsidy reserve plus capital will increase to the point at which the firms become “too safe to fail.” This will be reassuring to taxpayers and regulators but will result in diminishing returns on investment for shareholders.

Alternatively, they can shrink by selling subsidiaries or spinning off divisions to shareholders. In this process, portions of the subsidy reserve will be allocated to the divested entities. Divest enough, and the firms are no longer TBTF and no longer required to maintain the subsidy reserve.

The shareholder-driven approach we are proposing is one that politicians and bankers of all stripes can get behind. It is self-policing, and it can be readily adopted on a global basis.

The subsidy reserve will, in a meaningful way, remedy the harm unleashed by the random use of bailouts during the 2008 financial crisis. Best of all, the markets - not taxpayer subsidies and central planning by government - will determine the winners and losers.

William M. Isaac was chairman of the Federal Deposit Insurance Corp. and is author of “Senseless Panic: How Washington Failed America” (Wiley, 2010). Cornelius Hurley, director of the Boston University Center for Finance, Law & Policy, was assistant general counsel at the Federal Reserve Board.