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White House: 'Too Big to Fail' Is Here to Stay

June 17, 2009

By Nicole Gelinas

The White House has released its 88-page blueprint for financial-regulatory reform. The report makes clear that Washington does not want to eradicate its “too big to fail” approach to financial firms, but instead wants to formalize and expand it.

In the report, the Obama administration addresses a big problem. Bad financial firms have no way to fail without destabilizing the financial system and the economy.

The FDIC doesn’t have the authority to wind them down, as it does with depository banks. Bankruptcy is sometimes inadequate to address the systemic risks to the economy, as we saw in the Lehman Brothers case.

So the administration has jumped wildly from bailout strategy to bailout strategy in the cases of AIG, Bear Stearns, Citigroup, and others.

But “too big to fail” did its real damage well before the credit crisis started.

With a few exceptions, for a quarter of a century, the government has made it clear that when it sees a threat to the financial system, it will step in and protect the lenders, bondholders, and other creditors of financial firms, including the firms’ trading partners, from their losses.

Lenders, knowing that they have such government protection, have readily provided banks and investment firms with cheap money. Financial firms have used that cheap money and absence of skepticism to take reckless risks.

This lack of market discipline helped precipitate the credit crisis.

Now, Obama wants to strengthen the “too big to fail” policy.

Specifically, the administration proposes that the Treasury Department gain a new authority, with case-by-case approval from the Fed and the FDIC, to resolve a foundering firm “in situations where the stability of the financial system is at risk.” The Treasury, in “extraordinary times,” could establish a conservatorship for a failing firm, running the firm indefinitely.

Under its new power, the Treasury could “provide for the ability to stabilize a failing institution … by providing loans to the firm, purchasing assets from the firm, guaranteeing the liabilities of the firm, or making equity investments in the firm.”

The Treasury would also “have the authority to transfer the firm’s derivatives contracts to a bridge institution and thereby avoid termination of the contracts by the firm’s [trading partners].”

In other words, the White House would formalize the ad-hoc bailout policy that the government has followed now for more than a year.

True, in future bailouts, the White House would direct the Treasury to consider “the action’s cost to the taxpayers, and the action’s potential for increasing moral hazard.” (Moral hazard is the risk that protection now could encourage recklessness in the future.)

But nowhere in the document does the White House acknowledge that it must design a way in which lenders to financial firms can take their warranted losses in an orderly fashion. Many thoughtful people, including the University of Texas’s Jay Westbrook, former St. Louis Fed chief William Poole, and a trio of eminent economists have suggested elegant ways for that to happen.

Nor does the White House acknowledge that one of bankruptcy’s great benefits is consistency. Consistency allows lenders and other creditors to reasonably assess their prospects for recovery.

Nor does the White House acknowledge that the government’s goal, in winding down a failed firm, should be to sell the firm’s pieces to the private sector as quickly as practically possible.

This formalization of a lack of market discipline and consistency will overwhelm any of the reasonable regulations that the White House has suggested.

How? Means and motive.

Financial firms’ shareholders and employees will continue to assume that they enjoy the prospect of limitless profits. The people and institutions who underwrite the risk-taking — the bondholders, lenders, and trading partners — will assume that they enjoy limited risks.

Beyond making this fatal error, the White House saves its proposals on the other foundation of financial reform for the future. The Treasury will report on how to limit borrowing at banks and other financial firms by December 31.

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