Bill misses mark on ‘too big to fail’

Bipartisan negotiations on a financial reform bill had been making real progress over the last month, particularly toward truly ending “too big to fail” and replacing it with a strong resolution mechanism that would ensure that failed firms are liquidated. Unfortunately, Senate Banking Committee Chairman Chris Dodd (D-Conn.) pulled away from this approach at the urging of the Obama administration. His bill misses the mark in several key areas, perhaps none more important than its failure to truly end “too big to fail.”

Sen. Dodd’s bill would actually extend the FDIC’s ability to bail out failing firms through use of the Orderly Liquidation Fund. This newly proposed fund looks suspiciously similar to the Troubled Asset Relief Program, which has steadily broadened in scope from its original purpose.

The Orderly Liquidation Fund would be a $50 billion fund created through assessments on the largest 50 banks. While the fund is created with the laudable goal of “winding down” failing companies with minimal damage to the financial system, there are four major drawbacks to the detailed language of the bill.

First, it would further designate those firms who contribute to the fund as “too big to fail.” Pre-designating firms this way would give them a competitive advantage, as explained below.

Second, the Dodd bill doesn’t require liquidation of firms that go into the resolution mechanism, nor does it mandate steep losses for shareholders and creditors. There is no set, limited timetable for government support either. So while Sen. Dodd says that all of these things are intended, none are mandated. And we’ve seen what the government actually does in a crisis.

Third, removing $50 billion from the nation’s economy would dramatically affect the ability of large banks to make loans. This could mean as much as $200 billion in fewer loans made in the United States, resulting in slower economic growth and fewer jobs created.

And fourth, TARP has shown us that if a fund is created, Congress will find ways to turn it into a slush fund for picking winners and losers in the marketplace — a purpose far different from TARP’s original intent.

The Dodd bill also would allow a newly established systemic risk regulator to identify systemically risky firms and to require them to register with the Federal Reserve for direct supervision. Under the guise of providing extra regulation for the riskiest firms, this would essentially create an official “too big to fail” club. Given the bailouts of the last two years, this signal would likely create unintended and unfair advantages in the market for the largest firms at the expense of smaller firms.

A firm identified as having the official supervision of the Fed would likely receive lower costs of funds than smaller firms that aren’t deemed “too big to fail” by the systemic risk council. Creditors would be more inclined to lend to those firms. Quite simply, the largest firms would only get larger.

This is essentially what happened in the secondary mortgage industry when Fannie Mae and Freddie Mac became “too big to fail.” Smaller competitors withered, and Fannie and Freddie engaged in ever-riskier lending with the implicit backing of the federal government. The resulting fallout devastated our economy and left American taxpayers on the hook for hundreds of billions of dollars.

It’s clear that while this bill purports to address issues of systemic risk, it would have far-reaching negative consequences for our financial system. In addition to tacitly approving the “too big to fail” mindset and dramatically broadening the FDIC’s power to grant favored status to specific firms, the bill would establish a permanent mechanism for government bailouts of irresponsible firms.

Congress must be more specific in requiring the Fed to establish, in advance, firm rules determining what type of collateral it will accept against emergency lending, how much that collateral will be discounted in order to ensure against taxpayer losses, how the Fed and the Treasury Department will ensure that they’re not allocating credit and artificially propping up segments of the economy, and how Treasury will pay for any losses associated with the lending program to ensure that the Fed isn’t simply printing money and causing inflation.

Worse than failing to tighten the Fed’s bailout authority, the bill actually codifies the FDIC’s use of broad asset guarantee programs backing the debt of both banks and non-bank financial companies that some argue is an abuse of its authority. The taxpayer guarantee of these debts allows these companies to borrow money at drastically lower rates than normal and subsidizes the profits of the private company. And under the Dodd proposal, if the private market still won’t buy these troubled debt offerings, the Treasury secretary is empowered to purchase them. 

In short, the proposal would shift exposure from the most systemically risky firms directly to the shoulders of the American taxpayer by granting government backing to firms that federal regulators consider “too big to fail.” That’s a risk the American people don’t want — and one that Congress can’t afford to take.

Vitter is a member of the Senate Banking Committee.