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The Problem Of Deciding Who Is 'Too Big To Fail'

A man walks out of the the Bank of America Corporate Center June 30, 2005 in downtown Charlotte, North Carolina.
Davis Turner
A man walks out of the the Bank of America Corporate Center June 30, 2005 in downtown Charlotte, North Carolina.

In the era of massive bank bailouts, Democratic Rep. Barney Frank of Massachusetts and the Obama administration are trying to tackle the problem of what to do about financial firms that become "too big to fail."

The chairman of the House Financial Services Committee introduced a new bill Tuesday aimed at strengthening the government's ability to deal with troubled financial firms. But the bill carefully avoids answering perhaps the most obvious — and one of the most difficult — questions: Who, exactly, is too big to fail?

"It gets very hard to decide who is in and who is out," says John Douglas, who was general counsel to the Federal Deposit Insurance Corp. during the 1980s savings and loan crisis. "The real issue is trying to identify those institutions that are so interconnected in the economy — that their failure would be so disruptive to Main Street America — that you couldn't allow them to go out of business."


The question became an urgent one last fall, when Lehman Bros., the large investment bank, was allowed to collapse, triggering panic in the financial markets.

A number of other massive firms including Citigroup, Bank of America and American International Group have received tens of billions of dollars in bailout money from the U.S. government — along with what amounts to future guarantees from Washington to keep them afloat if they run into trouble.

Frank's bill is aimed at limiting the need for future bailouts by better monitoring and reducing systemic risk in the nation's economy.

Echoing a proposal by the Obama administration's Treasury Department, Frank is proposing to create a category of financial institutions that would be subject to increased requirements and scrutiny by federal regulators, but it leaves the details up to the regulatory agencies.

Does Size Really Matter?


Economists say size alone isn't enough to determine whether an institution's failure could have devastating ripple effects.

"A plain-vanilla, sizeable bank wouldn't necessarily fit this category," says Ernest Patrikis, who spent 30 years at the New York Federal Reserve Bank. "But a smaller organization could be doing business in such a way that it presents a larger risk profile."

Frank lays out in the draft bill a series of measures that a newly created Financial Services Oversight Council would consider before subjecting companies to increased scrutiny, including a firm's size, its importance as a source of credit and liquidity in the financial system, and, particularly, its interconnectedness with other financial institutions and markets.

"It's like the famous Potter Stewart line about pornography: I can't define it, but I know it when I see it," says Dean Baker, the co-director of the Center for Economic and Policy Research in Washington. "It may not be possible to write down a set of financial guidelines, but we can probably recognize in most cases which institutions are too big to fail."

'No Place To Hide'

Of course, it's not just banks anymore. One key change in Frank's bill is to bring all kinds of financial services firms, including investment banks and insurance companies, under the clear authority of federal regulators, primarily the Federal Reserve.

"There is no financial entity in the country that will be unregulated by the end of this," says Steven Adamske, the communications director for the House Financial Services Committee. "There will be no place to hide."

The list of companies facing tighter regulatory standards will not be made public. But those firms could face stricter requirements, such as maintaining higher levels of capital or liquidity. Some could also be required to maintain a plan for how the company would be liquidated if it becomes insolvent.

Congressional aides insist that these companies will not be given any kind of guarantees against failure, but many economists are concerned that the designation will end up being interpreted by the firms as a tacit promise of a bailout.

"The danger is what economists like to call moral hazard," says Douglas, the former FDIC official who is now a partner at the law firm Davis Polk. "You in essence can gamble, and if you win, you and your stockholders get the benefit. If you lose, the government is somehow going to bail people out."

Aside from the costs to taxpayers of any bailouts, there are other risks to an implicit government guarantee of some sort of bailout: It could, for instance, lead to managers making increasingly risky decisions.

"As long as the creditors expect their investments to be protected in those institutions, on average, too much risk-taking will go on," says Gary Stern, who recently retired as the president of the Federal Reserve Bank of Minneapolis. "You will still be faced with the heart of the too-big-to-fail problem."

A Problem Too Big To Get Rid Of?

It's a problem that has, if anything, gotten worse over the past year. For one thing, the nation's biggest financial firms have only gotten bigger, in many cases with the government's encouragement. For example, Bank of America bought Merrill Lynch as part of a government bailout last year, one of several similar deals.

"We have a much more concentrated financial industry as a result of the financial crisis than we did a year ago," Baker says. "We have several firms that are clearly too big to fail. So the question is, do we have the regulatory structure to deal with it?"

Frank's bill does aim to give regulators more power to force change in how these companies operate — or shut them down if they become insolvent.

Perhaps the most important change would give the federal government authority to wind down, or liquidate, non-banks. The FDIC has closed more than 100 banks so far this year, but U.S. officials say no regulator was capable of safely liquidating insurer AIG when it collapsed.

Frank's bill would expand the FDIC's role to cover other financial firms. Firms with more than $10 billion in assets would be responsible for covering the costs of their liquidation.

More broadly, there appears to be a growing acceptance in the financial community that changes are needed to deal with the problem of massive financial institutions.

"It's a bad long-term policy to have anyone too big to fail," Jamie Dimon, the head of JPMorgan Chase, the nation's second largest bank, told a Wall Street audience Tuesday. "There is a need to be able to take these firms apart and let them go away."