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Smaller Banks May Be Forced To Subsidize "Too Big To Fail"; Leading House Dem Wants To Change That

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-This story has been updated-

A leading House Democrat plans to introduce Thursday a provision that would require those banks deemed "too big to fail" to fund their own insurance fund -- in response to concerns from economists and mid-sized banks calling the existing proposals for smaller banks to pay into the fund illogical.

An insurance fund would pay for the orderly unwinding of one or more of the "TBTF" banks if they fail. But the current proposals call for taxpayers to pay the creditors of a TBTF firm should it fail or be forced to shut down by regulators. Then, financial firms with $10 billion or more in assets would pay taxpayers back.

Rep. Brad Sherman (D-Calif.) will introduce an amendment to a bill in the House Financial Services Committee to raise the existing threshold to either $50 billion or $75 billion, he told the Huffington Post on Wednesday night. Those thresholds could rise in the future should he make them inflation-adjusted, he said.

There's no firm definition for what constitutes TBTF. But there are 23 bank-holding companies with more than $100 billion in assets, according to the latest federal data available. Seven of them are above the $500 billion level; four are above the $1 trillion threshold. Those four -- Bank of America, JPMorgan Chase, Citigroup and Wells Fargo -- collectively hold $7.4 trillion in assets. To put that in perspective, that's 52 percent of the country's total output last year.

Sherman's move comes after medium-sized banks complained that the previous proposal -- introduced by committee chairman Barney Frank (D-Mass.) -- unfairly targeted them to pay for a big firm's failure. Under the existing proposals, a bank like the Third Federal Savings and Loan Association of Cleveland, with its 38 offices, would have to contribute to a fund that could one day pay for the failure of a Citibank, which has more than 1,000 offices nationwide. Citibank's parent company, Citigroup, has about $1.9 trillion in assets; Third Federal Savings and Loan has less than one percent of that.

The Federal Deposit Insurance Corporation has long been taking over and winding down medium-sized banks in an orderly fashion, argue those banks. The firms deemed "too big to fail" are those that the FDIC would have trouble taking over, like a Washington Mutual, a $307 billion behemoth that was pushed into a shotgun marriage with JPMorgan Chase, or those that the agency doesn't have the authority to take over, like a Lehman Brothers. Hence the need for new federal powers and a new insurance fund.

But another problem with the current proposals, say legislators, bankers and economists, is that it calls for taxpayers to foot the bill first in the case of a firm's failure, and then be repaid over time by the remaining targeted firms through after-the-fact assessments. Both the Frank bill and the proposed bill put forward by Senate Banking Committee Chairman Christopher Dodd (D-Conn.) include this provision.

"It almost seems like a joke to me," said Dean Baker, co-director of the Center for Economic and Policy Research in Washington, D.C. In the case of a rogue institution going under, the after-the-fact tax isn't fair to those firms that played by the rules. And as a practical matter, the tax doesn't make sense because the large, interconnected, systemically-important firms -- those so-called "too big to fail" companies -- are so intertwined that if one fails, many could soon follow, he said. That's what happened in the fall of 2008, when in a ten-day span Merrill Lynch was pushed to merge with Bank of America, Lehman Brothers declared bankruptcy, AIG got the first of its many billions in bailouts, and Washington Mutual collapsed.

Gerald Epstein, an economist at the University of Massachusetts at Amherst and co-director of the Political Economy Research Institute, called the plan a "chimera."

"I think it's a way of just having to postpone the cost again," he said, alluding to last year's taxpayer-funded TARP plan.

"In either scenario it doesn't make a lot of sense," Baker added.

It also doesn't make sense to Russell Goldsmith, the president and CEO of California-based City National Corporation, a bank-holding company with $18 billion in assets.

"They're creating a fund where the benefit is going to go to the...biggest financial firms in the country, yet they're asking lots of other companies, much, much smaller in size...to pay a tax into this fund, but we get no benefit," Goldsmith told the Huffington Post. "The United States government is not going to let them fail. The notion that [mid-sized firms] should be taxed so that Goldman Sachs, Citigroup and Bank of America get special protection, and by the way gives them a competitive advantage in addition, is just totally inappropriate and unfair."

"It's like Citigroup's headquarters has had a big fire, and we're being told we have to pay for part of their fire insurance premiums," he said.

In addition to Sherman's proposal, Rep. Luis Gutierrez (D-Ill.) and a few others will offer an amendment today to alleviate the situation. While Sherman's provision calls for raising the threshold so medium-sized banks aren't hit with the tax, Gutierrez's amendment would require firms to fund their insurance before a failure, and would cap total future taxpayer bailouts at $200 billion. That amount could be reduced to $50 billion as firms pony up the cash for the TBTF insurance fund.

Steve Verdier, senior vice president at the Independent Community Bankers of America, said a pre-funded insurance plan for TBTF firms could have the added incentive of discouraging banks from getting too big.

The economists Baker and Epstein agreed, though cautioned the incentive wouldn't be as strong as some might hope.

"The incentive approach is the smart way to go. Let's build in as many incentives as possible to discourage them," Verdier said.

But, he added, "It'll be a freaking miracle" if enough of those incentives were actually passed into law.

"People never seem to quite remember that the bigger they come, the harder they fall," Verdier said. "It will take a heroic effort to discourage these [banks] from becoming too large."

Sherman said he favored setting the minimum asset size-based threshold for firms at $75 billion, which would be inflation-adjusted -- important to note because that threshold would increase over time. He also wants a pre-funded insurance plan. But in the interview, he acknowledged it would be an uphill fight.

For example, though he prefers a $75 billion floor, he may end up offering an amendment that calls for extra taxes on firms with more than $50 billion in assets. The reason?

"I could get more votes," he said. "My preference is to draw the line so that those that are paying into the fund are those whose creditors might be bailed out since they're the ones getting the lower cost of funds."

In a September study, Baker and a colleague calculated that since the failure of Lehman Brothers in September 2008 and the ensuing bailouts, which enshrined TBTF, the 18 largest bank holding companies enjoyed significantly lower borrowing costs than normal. He pegged this taxpayer-funded subsidy at $34.1 billion a year.

"I draw the line at $75 billion because I don't know anybody smaller than 75 who would ever be considered systemic[ally significant]," Sherman said. "If I could pass it at 75, I would. My best analysis is that drawing the line at 50 gives me a better shot."

Asked if his amendment will pass, Sherman said, "I'm not that confident, but we'll see."

-UPDATE: An amended version of the Gutierrez amendment -- it was changed to reflect Sherman's view that the minimum threshold be set at $50 billion -- passed Thursday.-

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