One goal of Obama's 'sweeping overhaul': prevent another AIG

The plan seeks to contain the risk of large-firm failure. It would also give regulators alternatives to costly AIG-style bailouts.

By , Staff writer

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    A number of large firms that were at risk, such as Bear Stearns, have been absorbed by other giants that were already among the top 10 banks in size. Citigroup, on the other hand, is trying to go the other way and sell some of its divisions.
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Even if President Obama gets his way on banking reforms, some financial firms will remain so huge that their collapse would put the whole economy at risk.

It's a problem called "too big to fail," and it stood at the center of the US financial crisis last fall.

Back then, the government found itself doing extraordinary things, such as becoming the 80 percent owner of America's largest insurance firm, rather than take the risk that a corporate failure might cascade into a wider meltdown.

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Yet by stepping in to save firms like AIG, the government may have expanded the too-big-to-fail problem.

The largest firms have heard "no more Lehmans" become a mantra for policymakers. That refers to the bankruptcy of investment bank Lehman Brothers, which caused severe market disruptions last September.

Simply put, Wall Street titans know more clearly than ever that they won't be allowed to fail.

This is one reason that Mr. Obama says regulatory reform is needed, and soon. His plan seeks to contain the risk of large-firm failure. It would also give regulators alternatives to costly AIG-style bailouts if such a firm fails.

"If you can pose a great risk, that means you have a great responsibility," Obama said Wednesday in announcing his plan. "We will require these firms to meet stronger capital and liquidity requirements [than smaller banks]."

If his plan is adopted, the higher capital standards would represent a kind of tax on being big.

The plan also has a new "resolution authority," which would allow the government to take over failed giants – just as the Federal Deposit Insurance Corp. does with small banks that collapse.

"We should not be forced to choose between allowing a company to fall into a rapid and chaotic dissolution or to support the company with taxpayer money," Obama said. "That's an unacceptable choice."

But even with the new resolution powers, costs could be imposed on taxpayers, some finance experts say. More should be done, they argue, to restrain the size and complexity of financial firms.

At a congressional hearing in April, economist Simon Johnson argued that a firm that's too big to fail should also be deemed too big to exist.

Mr. Johnson, a former chief economist at the International Monetary Fund, suggested that regulators might be able to use antitrust law to break up "oligarchies" in the financial industry.

Although there are more than 8,000 banks, 19 large ones account for about half of US bank lending.

Obama's plan wouldn't curb the size of big firms. Nor would Obama seek to restore the separation of plain-vanilla banking from more-complex securities dealing – the Glass-Steagall law that lasted from the 1930s through the 1990s.

Moreover, as the financial crisis has progressed, some of the largest firms have been growing even bigger through mergers. A number of large firms that were at risk – Bear Stearns, Washington Mutual, Wachovia, Merrill Lynch, Countrywide – have been absorbed by other giants that were already among the top 10 banks in size. (Citigroup, so big and unwieldy that a merger is unlikely, is trying to go the other way and sell some of its divisions.)

"There’s a delicate balancing act that the administration is trying to navigate through," says Doug Rediker, a former investment banker now at the New America Foundation. Businesses, including banks, naturally want to keep growing. With large size comes added risk for the system, yet it's not easy just to put a cap on the size of banks, he says. That is "much harder to implement than the idea would seem to imply."

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