BUSINESS

ANOTHER Fed Official Says Senate Bill Doesn't End 'Too Big To Fail'

Jun 11, 2010 | Updated May 25, 2011

The Senate financial reform bill serving as the base text for Congressional negotiations doesn't end the perception that the nation's largest financial firms are Too Big To Fail, another top Federal Reserve official said Friday.

Federal Reserve Bank of Philadelphia President Charles I. Plosser is the latest regional Fed chief to criticize the bill for its apparently inadequate attempt to forever end Too Big To Fail, joining a growing group that includes Dallas Fed President Richard W. Fisher and Kansas City Fed President Thomas M. Hoenig.

"We must work to restore the prospect of failure," Plosser said in prepared remarks to a gathering in Altoona, Penn. "To do so, we must establish a credible commitment by the government to not intervene or bail out firms on the verge of bankruptcy."

That's what happened in 2008 as the federal government propped up investment firm Bear Stearns, insurer AIG, mortgage giants Fannie Mae and Freddie Mac, as well as the nation's largest banks. More than 800 companies have either received or have been promised hundreds of billions of dollars in taxpayer cash.

But, Plosser said, the approach favored by the Democratic leadership in the Senate as well as by top officials in the Obama administration to ensure that never happens again doesn't go far enough, and leaves taxpayers on the line should the financial system near another crash.

"I believe the best approach is amending the bankruptcy code for nonbank financial firms and bank holding companies, rather than expanding the bank resolution process under the FDIC Improvement Act as both versions of the reform legislation appear to do," he said.

"Resolution processes can be highly inefficient and arbitrary -- granting far too much discretion to regulators or politicians to rescue some stakeholders and not others.

"[I]t is important that we recognize that rules and regulations can have unintended and often undesirable consequences," Plosser continued. "While the proposals now before Congress claim to have solved the Too Big To Fail problem, I am less convinced."

The House and Senate have each passed a financial reform bill, which the Democratic leadership in both chambers as well as the Obama administration claim will fix the ailments in the financial system that led to the worst financial crisis since the Great Depression. Lawmakers are in the process of reconciling these bills into a single version acceptable to both houses of Congress before sending the final version to President Barack Obama.

The importance of forever ending Too Big To Fail can not be understated, according to Plosser and his counterparts across the Fed's regional banks.

"I believe that one of the most important objectives of financial regulatory reform is to address the notion that some firms are Too Big To Fail," Plosser said. "The recent crisis and actions by policymakers have exacerbated moral hazard and expanded the safety net for failing firms. This is a huge problem that if not adequately addressed will sow the seeds of the next crisis.

"If a firm's creditors believe that the government will rescue them in the event of an impending failure, they will have little incentive to discourage the firm from taking excessive risk. Failure is the ultimate form of market discipline and an essential element of free enterprise.

"Individuals must have the freedom to reap the rewards of their success, but they must also be free to fail. As my friend and fellow economist Allan Meltzer has said, "Capitalism without failure is like religion without sin. It doesn't work."

Meanwhile, administration officials, like Obama's top economic adviser, Larry Summers, argue that had the proposed resolution process been in place around the time taxpayers were bailing out AIG, the bailout wouldn't have been necessary. Officials at the New York Fed and the Fed's Board of Governors in Washington make similar claims.

Analysts at Moody's Investors Service said in a report last week that they doubted whether the proposed legislation truly ends Too Big To Fail, noting that regulators and policymakers would inevitably step in if a systemically-important firm was on the verge of collapse, since by definition such a firm's dissolution would threaten the broader financial system.

Such financial behemoths -- which many observers believe to be Bank of America, JPMorgan Chase, Citigroup, Wells Fargo, Goldman Sachs and Morgan Stanley, among others -- enjoy the support of an implicit government backstop. This allows them to issue debt at lower costs than their competitors because their creditors credibly believe that they'll be bailed out should times get rough. Collectively, the firms save billions of dollars a year thanks to this implicit government guarantee.

Fisher, the Dallas Fed chief, and Hoenig, of the Kansas City Fed, argue that the best way to end Too Big To Fail is to break up the nation's megabanks.

In a speech last week, Fisher said the nation doesn't need "a few gargantuan institutions capable of bringing down the very system they claim to serve."