Who's really too big to fail?

Let some troubled financial firms fail, U.S. regulators tell Congress. Fannie Mae and Freddie Mac are exceptions.

America's top financial policymakers have a message about the government's role in times of turbulence: Bailouts not necessarily included.

"Allowed to fail." That's the way Treasury Secretary Henry Paulson, in a congressional hearing Thursday, said financial companies should generally be treated.

"Orderly liquidation," said Federal Reserve Chairman Ben Bernanke at the same hearing, outlining a possible response if a prominent securities firm faced bankruptcy.

Their words don't mean that the government is withdrawing from its backstop role in financial markets. In fact, the importance of that role was underscored this week as mortgage giants Fannie Mae and Freddie Mac saw their share prices plunge to levels not seen since the early 1990s. The two companies are so central to the home-loan industry that in a crisis regulators would have to step in.

Still, after cooperating to arrange the March rescue of securities dealer Bear Stearns, Mr. Paulson and Mr. Bernanke are reminding investors that government support has its limits.

Congress is considering how to reconfigure the nation's bank regulations after a year of turmoil and a decade of rapid change in financial markets.

Both the Treasury secretary and the Fed chairman say that such legislation is needed – including new regulatory powers to ensure the safety of the financial system on which Americans rely.

But in the hearing, they took care to stress that such moves will not be successful if investors and firms perceive themselves as shielded from often-harsh discipline of the marketplace.

"For market discipline to be effective, market participants must not expect that lending from the Fed, or any other government support, is readily available," Paulson said in his testimony. "For market discipline to effectively constrain risk, financial institutions must be allowed to fail."

The Bear Stearns intervention has raised the question of whether regulators now consider the largest investment banks – firms that originate securities like stocks and bonds – to be too big to fail. That is, the government will bail them out rather than risk a collapse that would affect the entire financial system.

Economists consider a few of the largest commercial banks to be too big to fail, although this is not enshrined as official policy.

Responding to a direct question on the four largest investment banks, Bernanke declined to call them too big to fail.

He said that in the case of Bear Stearns, the Fed had a complex mix of reasons to step in with a loan and arranged merger with the bank JPMorgan Chase. Bear's size played a role, Bernanke said, but the move also was underpinned by broader market tensions at the time and by poor functioning of certain financial markets to which the company was connected.

He said the goal of legislation – and of preserving market discipline – is to make sure the need for such a rescue does not arise again.

Preserving market discipline while preventing market meltdown is an age-old balancing act for financial regulators. Now these regulatory challenges are being faced in connection with a world where investment banks play a larger role in the flow of credit, because loans are increasingly packaged into securities rather than held by traditional banks.

"In light of the Bear Stearns episode, the Congress may wish to consider whether new tools are needed for ensuring an orderly liquidation of a systemically important securities firm that is on the verge of bankruptcy," Bernanke said in his testimony. And he called for "a more formal process for deciding when to use those tools."

It's possible that Congress will decide to give the Fed a formal role in supervising large investment banks – including setting standards for the amount of capital they must hold in reserve to offset the investment risks they take.

At the hearing, Paulson said that the industry has taken on more leverage, or risk, than was healthy.

If a large investment bank failed, the role of rescue or liquidation might fall to the US Treasury. The department's Federal Deposit Insurance Corp. now plays that role for much of the commercial banking industry.

Paulson said the need for such legislation is urgent, but he acknowledged that it will take lawmakers some time to work through the details of reforming financial regulation. That means a law might come next year, not sooner.

Rep. Barney Frank (D) of Massachusetts, who chairs the House Financial Services Committee, said that current regulatory powers should be adequate until then, as indicated by the Bear Stearns rescue. He said it's more important to get the legislation right than to do it quickly.

"It's very difficult" to find the right balance between free markets and government oversight, says Henry Hu, a corporate law expert at the University of Texas in Austin. The investment banks are important enough that a failure poses risks to the world financial system, he says. Yet tighter regulation could have drawbacks, such as if the industry lost in dynamism what it gains in stability.

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