Financial reform bill: What does it do about firms deemed 'too big to fail'?

Financial reform legislation hammered out Friday between the House and Senate is the biggest set of new bank regulations since the Depression. But experts disagree on whether it can eliminate 'too big to fail' banks and prevent future bailouts.

By , Staff writer

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    A worker leaves the London branch of failed bank Lehman Brothers in 2008 – a bankruptcy that contributed to a near-meltdown of the financial system. Will Congress's financial reform bill keep large firms from becoming 'too big to fail,' a standing that implicitly guarantees them a government bailout? Experts are divided.
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Financial reform legislation hammered out early Friday morning by House and Senate lawmakers is supposed to protect the US against another credit crisis, but experts are split on whether the bill would end the "too big to fail" mystique surrounding some financial institutions.

Obama administration officials say that it would. Regulators would have new powers to seize and dispose of failing financial firms, they point out, which would deter those firms from becoming too large and reckless.

Other experts aren’t so sure. There is nothing specific in the legislation that would allow the federal government to limit the size of banks or other institutions, they say. Without such a cap, banks and other financial entities will continue to grow to the point where their failures might threaten to badly damage the entire US economy.

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“As far as I can see the ‘too big to fail’ problem is still in place,” says Anthony Sanders, a professor of finance in the School of Management at George Mason University.

Many analysts say the economy is distorted by the widely held perception that some financial firms are so large the US government can’t afford to let them fail. Such an implicit federal guarantee allows these behemoths to borrow at cheaper rates, because the markets see them as safer investments. The firms themselves may take risks they might otherwise have shunned, figuring that even if they mess up, Uncle Sam will be there to bail them out in the end.

To see “too big to fail” in action, just look at the events of September 2008, say economists. The giant insurance firm AIG suffered a liquidity crisis, and the Bush administration effectively nationalized the firm, fearing that it was so intertwined with other financial giants that if it took a swan dive it would bring half of Wall Street down with it. At the same time, the Bush team allowed Lehman Brothers to go under. That move proved to be an exception that proved the rule, as the Lehman bankruptcy froze credit markets and indeed may have accelerated the world financial meltdown.

The financial reform bill attempts to address this problem by creating a halfway station between bailout with taxpayer dollars and bankruptcy. Banks and other large financial firms would have to create “funeral plans” indicating how they could be broken up and shut down with as little damage to other firms as possible.

Federal regulators would gain new powers to seize troubled firms in cases where they believe bankruptcy might destabilize the financial system. The Federal Deposit Insurance Corp. (FDIC) would then unwind the company in question, breaking it up and selling off pieces. The Treasury would provide upfront money to fund this process, but the government subsequently would attempt to recover its expenses by levying fees on healthier financial firms with assets of $50 billion or more.

These new powers would establish a credible threat that the government would allow even the biggest of firms to go under, since officials would set up an orderly procedure to deal with the aftermath, according to administration officials. That would mean the biggest firms would not make overly risky decisions, they say.

“This is a kind of a nuclear bomb that you hope you never have to use,” said FDIC Chairman Sheila Bair on Monday in a video interview posted on The Wall Street Journal website. “That fact that it’s there, I think, is going to be important. And if we have to use it we will.”

However, the most direct approach to dealing with the "too big to fail" problem would be to limit the size of financial firms in the first place. There is little but vague language in the financial bill on size caps, however.

Mr. Sanders of George Mason University points out that the so-called Volcker Rule, named for its proponent, former Federal Reserve Chairman Paul Volcker, would have indirectly limited the size of banks by prohibiting them from trading for their own accounts. In the end, however, this rule was watered down, and banks will be able to continue to make investments up to 3 percent of their tangible equity.

For this and other reasons, Sanders himself does not favor the legislation.

“It’s nothing but a tax on big banks and a Consumer Financial Protection Agency,” he says.

Some other experts take a different view, saying that while it is not perfect it contains some important steps.

“The bill will not eliminate financial crises, but it will make them less frequent and considerably milder, which is all we can realistically accomplish,” writes Douglas Elliott, a fellow in financial studies at the Brookings Institution, in an analysis of the House-Senate compromise legislation.

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