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Too Big To Fail and Bailouts Are Here to Stay

Too Big To Fail and Bailouts Are Here to Stay

By Robert Robb - May 1, 2010

Now that Senate Republicans have produced their own proposal, this much is known for certain: after Congress finishes doing whatever it is going to do regarding financial market reform, the country will still have financial institutions policymakers regard as too big to fail. And when the financial system is again under stress, there will be more bailouts.

The narrative driving financial market reform is this: Large financial institutions took too many risks and were overleveraged. They were all so interconnected that failure of one would be a contagion that might collapse the entire U.S. financial system. So, the federal government had no choice but to step in and bail them out.

I believe that this narrative is false. I believe that policymakers could have and should have allowed the financial markets to sort themselves out through write downs and bankruptcies. I believe policymakers panicked and overreacted.

That, however, is very much a minority view, and a very small minority at that. So, accepting the narrative for purposes of discussion, what should be done to keep taxpayers from being on the hook to bail out large financial institutions when they get in trouble?

The most obvious way is to make sure they don't exist. Pass laws limiting the size, scope and activities of financial institutions so that there are none so large, leveraged and interconnected that policymakers are unwilling to let them fail.

That might not make for the most efficient and effective capital markets. But the U.S. has made do with small banks with limited activities before. We could do it again.

Although some in the Democratic Party favor such an approach, it's not being advocated by the Obama administration or leading Democratic members of Congress on the issue. Instead, they have chosen the rule by a committee of wise men approach.

Large financial institutions would continue to exist. They would have to do some things differently, but nothing that materially affects their market presence or functions.

Instead, a committee of regulators would inspect them for systemic risk.

The committee of wise men could make ad hoc decisions about the activities of large financial institutions deemed large or interconnected enough to potentially pose a systemic risk. It could order individual companies to increase capital or decrease leverage, or reduce or eliminate certain products or lines of business. It could even decide to take them over and liquidate them.

This week, Senate Republicans finally offered their alternative to the Democratic approach. It was a colossal disappointment.

Republicans would also rely on a committee of wise men approach. Their committee would have a slightly different composition, slightly different procedures and slightly different powers. But protecting the country against bailouts would still depend on ad hoc decisions made by regulators about the operations of financial institutions they believe large enough to bring down the entire financial system.

This committee of wise men approach would represent a fundamental change in the nature of American capitalism. Right now, only companies and their creditors can make the decision to put them into bankruptcy. The only exception is banks whose deposits the federal government guarantees.

Under both the Democratic and Republican proposals, the federal government can decide to liquidate any company the government deems to pose a systemic risk.

Both claim that such liquidations won't involve bailouts. Shareholders and creditors will take it in the shorts.
Whether that will be the case when the time really comes is doubtful. But it's also irrelevant.

The feared contagion that justified the last bailouts was doubt about the ability of large financial institutions to make good on the deals they had made with other large financial institutions. If there are doubts that a large financial institution can uphold its end of deals, providing that confidence requires government cash or credit. A bailout to counterparties is as much a bailout as one to shareholders or creditors.

Both political parties have promised to end too-big-to-fail and taxpayer bailouts of large financial institutions. Neither has advanced proposals that would actually do that.

Robert Robb is a columnist for the Arizona Republic and a RealClearPolitics contributor. Reach him at robert.robb@arizonarepublic.com

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