Friday, October 30, 2009

Too Big To Fail Legislation Introduced

Representative Barney Frank and Treasury Secretary Timothy Geithner introduced and defended this week new federal legislation that seeks to address the "too big to fail" financial firm problem that we've discussed on this blog several times previously. In short, the bill would create an executive branch council, the Financial Services Oversight Council, which would be delegated broad powers to oversee and promulgate regulations over firms designated as "too big to fail." This oversight council would be composed of representatives from the Treasury Department, the Federal Deposit Insurance Corp., the Securities and Exchange Commission, and other various bank regulators that would be given the power to "invoke the authority" to provide funds to "wind down" insolvent institutions.

The proposed legislation, which set off a firestorm of criticism in Congressional hearings yesterday, would give power to the Financial Services Oversight Council to establish capital asset requirements and "be responsible for identifying companies and financial activities that pose a systemic threat to the markets and subject those institutions to greater oversight, capital standards and other regulations," including winding them down if the systemic threat would damage the national and global economy. Three of the most contentious issues already raised include (1) who will pay for the winding down of the failing behemoth institutions, (2) what cap might be set as an asset figure that will make a firm "too big to fail," and (3) whether the Government's list of potential "too big to fail" firms will be made public.

As to the first issue, who will pay for the winding down, the bill proposes that "financial institutions would not be required to pay fees in advance to fund a pool of capital. Rather, the government would first borrow taxpayer dollars from the Treasury Department and afterwards recoup the costs from assessments on financial institutions with $10 billion or more in capital." This proposal has critics up in arms suggesting that regional banks will become the new "taxpayer bailout" target as regional banks with assets of $10 billion or more will foot the bill if enormous financial institutions fail. Critics argue that an up-front insurance tax on all "too big to fail" financial institutions makes much more sense than an "after the fact" taxpayer funded bailout (through the Federal Reserve) to be reimbursed later by financial firms with net assets of $10 billion or more.

As to the second issue, whether a cap on assets is necessary to properly regulate "too big to fail," a number currently debated is capping assets at $100 billion. This number is, according to critics, just one tenth the size of some already existing financial institutions. In addition, Fed Reserve chair Ben Bernanke does not seem to think that any cap is mandatory, as it might hinder the borrowing needs of global institutions.

To the third, issue, whether to make public those firms identified by the Government as potentially "too big to fail," the proposed legislation seems to be contradictory as to when and if these firms should be made public. Critics suggest that a potential public identification could have deleterious impact on financially sound firms that just happen to have an enormous amount of assets on its books and might imply to the public that these firms would assuredly be bailed out by the government in the event of overleveraging and reckless management.

As argued by Steve Ramirez yesterday, now that the bill has been proposed and defended, critics, lobbyists and opponents will no doubt line-up with great purpose in order to kill the legislation. Whatever the merit of the proposal, the amount of lobbying and money that will be spent to kill this bill will be amazing.

For more on Too Big To Fail, see:

Professor Barclift: Too Big To Fail, Too Big Not to Know

Professor Ramirez: Subprime Bailouts and the Predator State

Professor Painter: Bailouts: An Essay on Conflicts of Interest and Ethics When Government Pays the Tab


  1. Professor cummings,

    Again, thank you for a wonderful and insightful post. I agree with you: it will be interesting to watch the amount of lobbying dollars expended to defeat this proposal. Also, I tend to think that the capital pool should come from the institutions that are subject to regulation. What do you think about the argument that too much strain is paced on regional banks (and other smaller institutions) to fund the capital pool? Thank you.

  2. professor grant:

    i come down on the side of the critics that think that the too big to fail and borderline too big to fail should pay into a "pre-failure" insurance account to fend off future collapses like lehman brothers and nearly bear stearns and AIG. for taxpayers to bailout the "too big to fail" first (via the fed), with the reimbursement coming from $10 billion and larger entities (including the regional banks) later, i think a system of "smaller bailing out the largest" is a phenomenon that could happen. leave the taxpayers out of it. those firms that choose to flirt with "too big to fail" should shoulder the responsibility of pre-payment into the bailout fund.

    just my first blush reactions to a bill that i have admittedly not read closely yet.

    thanks for the question.

  3. The first "to big to fail" institutions to be wound down should be Fannie and Freddie. Let us see the government get it's own house in order before claiming competence to regulate the private sector.

  4. anonymous, 10.30.09, 8:26 p.m.:

    nice comment. i agree that the government must get its own house in order with fannie mae and freddie mac.

    that said, can we really say that the private sector self regulated in any conceivable way leading up to the debacle that is the meltdown? leaving the private sector to its own devices would have destroyed the economy, it almost did. in my mind, we are other wholly capitalist (meaning that all the reckless institutions should have been allowed to fail, all of them, including aig, bear stearns, merrill lynch, etc) or we must regulate with force, and thoroughly.

    the in between, partly regulating, partly free market and self regulation, leads us into the morass we find ourselves.

  5. Fannie and Freddie had their own regulator, OFHEO! One regulator to watch two companies. And, yet, they failed in spectacular fashion bringing down other firms in their wake.

    The efficacy of regulation assumes disinterested, competent authorship and enforcement. This has proved an illusion. Failure, and the risk of failure focuses the mind, reducing "moral hazard" and ultimately leads to sounder business practices.

    You claim that allowing these firms to fail would have "destroyed the economy". I disagree. We have a lot of experience with bankruptcies. The downturn would have been sharper and shorter. The taxpayer would not be as extended. More importantly, businesses would have learned that, regardless of their position, failure is a real possibility.