Tackling the 'too big to fail' firms

Business Times - 03 Nov 2009


Tackling the 'too big to fail' firms

Bill grants Washington sweeping new powers to police giants, but would regulators be able to regulate themselves?

By LEON HADAR
WASHINGTON CORRESPONDENT

IT'S official! The recession is over. The American economy grew at a 3.5 per cent annual rate in the third quarter, bringing to an end a series of declines over four quarters that produced the Great Recession that started in December 2007 and is considered to be the most devastating downturn since the Great Depression of the 1930s.

But as officials and lawmakers in Washington study the latest better-than-expected gross domestic product numbers released last Thursday, they are focusing their attention on finding ways to prevent another economic crisis by dealing with some of the fundamental problems that led to the financial meltdown and the ensuing severe recession.

Hence, the head of a key House committee unveiled legislation last Wednesday that would grant the federal government sweeping new powers to police giant financial firms.

Under the draft proposal - to deal with the financial behemoths whose collapse could wreck the entire financial system - a new regulatory mechanism would replace the existing bankruptcy process that involves the 'too big to fail' financial firms.

The Treasury Department and Barney Frank, a Democrat congressman who is the chairman of the powerful Financial Services Committee, introduced this proposal. Democratic Senator Chris Dodd, who is chairman of the comparable committee in the Senate, is preparing a similar legislation for that chamber.

The bill is a response to pressure from the public furious with the fact that taxpayer money had to be injected into failing large financial institutions to help keep them afloat and avoid the mess that their collapse could have caused.

Public anger

Indeed, since the start of the financial crisis the government has injected hundreds of billions of taxpayers' dollars into firms such as Bank of America, Citigroup and American International Group (AIG), all deemed too big to fail. The most dramatic case was the infusion of US$190 billion into AIG, a decision that ignited public protests and angry speeches on Capitol Hill.

But the bill is also aimed at putting in place a new system that would prevent a long and muddled liquidation process involving large financial firms that could trigger a collapse of the entire financial system, similar to the one that led to the bankruptcy of Lehman Brothers.

'The problem we have is that, in a financial crisis, if you let the big firms collapse in a disorderly way, they will bring down the whole system,' Federal Reserve chairman Ben Bernanke explained in a recent address. 'We really need - and this is critically important - we really need a new regulatory framework that will make sure that we do not have this problem in the future.'

In fact, the proposed legislation assigns the Fed a central role in the new system, giving it authority to take over firms that are at risk of failing and endangering the nation's financial structure.

It would allow the government to dismantle a company without sending it through a standard bankruptcy. To pay for that process, banks and other firms with more than US$10 billion in assets would contribute to a special fund.

At the same time, shareholders and creditors of institutions would take losses, and top management could be removed. To put it in simple terms, the proposal would allow the government to liquidate a giant financial institution in an orderly way, rather than bail them out entirely or let them collapse.

The bill also would strengthen oversight, creating a new regulatory council overseen by the Treasury secretary, and including the Federal Deposit Insurance Corp, the Fed, the Securities and Exchange Commission and other bank regulators, to contain potential risks to the system.

This oversight council would identify companies and financial activities that pose a systemic threat to the markets and subject those institutions to greater oversight, capital standards and other regulations. Hence, banks could be forced to hold more capital. The council would have to invoke its authority in order to provide funds to wind down an insolvent institution.

The plan that would ensure for the first time that all firms that pose a systemic risk to the economy and financial markets would fall under the federal regulatory system, has already drawn criticism.

Lawmakers - both Republican and Democratic - at a hearing of testimony by Treasury Secretary Tim Geithner in the House of Representatives' Financial Services Committee on Thursday expressed concern over the broad authority to oversee financial markets that would be provided to the federal government, and especially to the Fed.

A permanent TARP?

Some critics suggested that the end result would be to establish a permanent version of the Troubled Asset Relief Program (TARP), a charge denied by Mr Geithner. 'What this bill does not do is provide a government guarantee for troubled financial firms,' Mr Geithner said. 'It does not create a permanent TARP-like authority.'

But another criticism centres on what seems to be a mixed message that the legislation may be sending to the financial markets.

One impression seems to suggest that the government will allow big firms to fail - but in an orderly way. But, in fact, investors could equally conclude that the government would not allow firms such as Goldman Sachs to go under - and that if push comes to shove, it would bail them out.

That raises one of the major problems highlighted during the recent crisis - the so-called socialisation of risk: The firms win if they make profit - and win again if they go under when the American taxpayer comes to their aid.

Moreover, the notion that other banks and firms with more than US$10 billion in assets would contribute to a special fund to pay for the liquidation doesn't take into consideration what would actually happen. Almost all such companies, big and small, would be in distress financially and wouldn't be able to contribute to such a fund. In that case, the money would certainly have to be provided by the taxpayer.

Another problem has to do with the role that the government, including the Fed, would have in identifying and containing systemic risks. In some cases, it was the government that may have created these systemic risks.

It was the federal government that encouraged mortgage companies to help poor customers purchase homes. The Fed lowered interest rates. The two decisions led to the housing bubble and helped create the conditions for the 2008 financial meltdown.

Would government regulators be able to regulate themselves?


Copyright © 2007 Singapore Press Holdings Ltd. All rights reserved.

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