By William Isaac, Published by American Banker

The Treasury has proposed a new bill it claims addresses “systemic risks” and “Too-Big-to-Fail” institutions. It does neither, and in fact it creates new moral hazards by extending the Federal safety net.

The bill would officially extend for the first time in history the government safety net to non-bank companies engaged in financial activities. Identification of firms systemically important enough to feel the government’s embrace is delegated to a council of unelected government officials.

The government will investigate and regulate the selected non-banking firms. It will be able to guarantee the debts of these firms, loan them money, force their sale in whole or in part, limit their growth, curtail executive compensation, eliminate dividends, and/or put them into involuntary bankruptcy. The cost will be borne by taxpayers until the unelected officials decide which companies to tax.

A recent example of this sort of unfettered government power was Congress handing Secretary of Treasury Henry Paulson $700 billion to use as he saw fit. He sold the “TARP” bill on the basis of purchasing “toxic assets” from financial institutions. Instead, Paulson invested it in the stock of banks, most of which did not need or want the money.

Paulson went beyond the banks, including GM, Chrysler, and GMAC. I cannot imagine a basis for declaring GMAC a systemically important institution, but Paulson nonetheless provided two infusions of TARP money.

Do we really want to give unelected officials a blank check to do more GMAC-type bailouts? Would it be too much to ask Congress to vote on any further bailouts rather than delegating the authority?

Excluding banks (which are covered by the FDIC and the Fed) and insurance companies (which are handled by the states) I cannot identify any systemically important financial company.

The bill is touted as ending “Too-Big-to Fail” (TBTF), which is simply not true. TBTF means that creditors of a bank do not suffer losses, it does not mean the bank and its shareholders are protected.

Lots of large banks have failed over the 25 years since the FDIC intervened in Continental Illinois. Rarely has a creditor of a large bank suffered a loss, although frequently shareholders were wiped out, as they were in Continental. This is, of course, unfair to smaller banks, whose uninsured depositors often incur losses.

The Treasury bill does not purport to change this outcome, nor should it. When we are in the midst of a banking crisis, the FDIC and the Fed must have the ability to calm the markets and prevent panics. Any bill to limit that authority would be foolhardy.

The FDIC wiped out the uninsured depositors when IndyMac failed in July 2008, which unnerved the markets. The FDIC protected all bank creditors at WAMU in September 2008, although holding company creditors were exposed to loss, which was disruptive.

When Citigroup proposed to purchase Wachovia in late September 2008 with FDIC assistance, no creditors of the bank or the holding company would have suffered any loss. No large bank has been allowed to fail since.

Clearly the regulators determined that the public had experienced as much financial instability as it could handle. I do not fault the regulators for that judgment – they should have gotten there sooner.

It is easy to talk and act tough when you are handling a single bank failure, even of a large bank. The problem is that large bank failures seldom come one at a time. The same conditions that push one large bank over the edge are almost certainly affecting other large banks.

No major government has ever forced the creditors of its largest banks to suffer losses in modern times. None ever will as it would collapse the economy. We need to find ways to diminish the likelihood of large banks getting to the edge of failure. The Treasury bill does little to accomplish this.

There are many reforms we ought to debate in Congress, including:

  • Establishing a strong and independent Systemic Risk Council to monitor and control major risks to the financial system. The Treasury bill’s Systemic Risk Council would be a very weak bureau of Treasury, which is one of the government agencies most in need of monitoring.
  • Considering re-enactment of the Depression-era law separating investment banking and commercial banking.
  • Folding the bank and holding company supervisory staffs of the Comptroller of the Currency, the Office of Thrift Supervision, and the Federal Reserve into a new, independent Financial Institutions Regulatory Authority (FIRA) to oversee all Federally chartered banks and thrifts and their holding companies. The FDIC would remain an independent watch dog with backup authority over the firms regulated by the FIRA and would also oversee state-chartered institutions and their holding companies.
  • Increasing over time large bank equity capital, loan loss reserve, and liquidity requirements.
  • Eliminating pro-cyclical accounting and regulatory rules, such as those that set capital and reserves, assess FDIC premiums, and impose mark-to-market accounting on long-term financial assets.
  • Considering how to rehabilitate and strengthen the SEC and put the Financial Accounting Standards Board under meaningful oversight by the Systemic Risk Council.

The efforts thus far of the Obama Administration to address the serious flaws in the regulatory and accounting systems which led to today’s crisis are very disappointing. The current bill is another example of the seeming inability to grasp what the problems are, much less the solutions.