BUSINESS
06/14/2011 06:45 pm ET Updated Aug 14, 2011

Wall Street Bailouts No Longer An Option, Regulator Says

The era of Wall Street bailouts is over, a top government regulator told Congress on Tuesday.

The financial reform legislation passed last summer bars future taxpayer rescues of financial firms, and it eliminates the need for bailouts by endowing regulators with greater powers, said Michael H. Krimminger, general counsel of the Federal Deposit Insurance Corporation, in testimony before the House Financial Services Committee. The new law, Krimminger said, should end the notion that some firms are too big to be permitted to fail.

But other experts who testified Tuesday challenged that vote of confidence. As law professors and another regulator spoke before the House committee, the hearing highlighted a central concern about the Dodd-Frank law: It may not change the way business is done on Wall Street. Despite requirements limiting firms' ability to take risks, some experts fear the financial system may continue to operate under the assumption that certain firms will be bailed out in times of crisis, in the event that other government efforts cannot stem collateral economic damage.

"It is too early to tell whether Dodd-Frank will ultimately be successful in ending 'too big to fail,' and that success will be dependent on the market's perception of the effectiveness of the actions taken by regulators and Treasury," Christy Romero, acting special inspector general of the bailout fund known as the Troubled Asset Relief Program, said.

"Taxpayers," she continued, "likely won't know about the extent of their continuing exposure until the next crisis."

Congress authorized a $700 billion taxpayer rescue of the financial system in the fall of 2008, as stock markets around the globe were plummeting and massively interconnected firms teetered on the edge of collapse. These companies could take down the entire financial system and even the broader economy if they were to fail, the thinking went.

The subsequent financial reform legislation aimed to end this trait of the financial system -- that a failing company could essentially force the government to extend emergency aid. Regulators adopted a new rule Tuesday ordering large banks to hold a minimum amount of capital against losses, a change required by the financial reform law. The rule is intended to make the banking system safer.

Last year's law also includes measures directly intended to prevent or ameliorate a firm's failure. Firms designated as "systemically important" must compose a plan to dismantle themselves in the event of a crisis. If these companies cannot demonstrate that they have this "living will," regulators could force them to restructure their operations, Krimminger said.

When crisis does strike, the government has the ability under the new law to seize a financial firm, a power similar to the FDIC's ability to seize failing banks. This ability, known as "orderly liquidation authority," or OLA, allows the government to gradually wind down a troubled company, keeping it out of legal bankruptcy and ideally preserving the value of its assets.

"Bailouts are not permitted," Krimminger said.

But the law allows companies in government receivership to borrow funds from the Treasury Department. These loans would automatically be repaid with the failed firm's assets, noted Michael S. Barr, a law professor at the University of Michigan who formerly served as the Treasury's assistant secretary for financial institutions.

This borrowing from the government smacks of a bailout, said Stephen J. Lubben, a law professor at Seton Hall University and a bankruptcy expert. Moreover, failing firms' dependence on taxpayers may continue, even with regulators' new power, Lubben said.

"The orderly liquidation of financial institutions under OLA is primarily achieved by virtue of the FDIC's ability to provide ongoing liquidity to the financial institution, which many would consider a form of bailout of the financial institution's counterparties," Lubben said..

As the House hearing wore on, a more fundamental, and perhaps more disturbing, thesis emerged: the actual ability of regulators like the FDIC to stem the damage from the next financial crisis will only be known once that crisis strikes.

Romero, the TARP special inspector general, quoted remarks from Treasury Secretary Tim Geithner.

"The size of the shock that hit our financial system was larger than what caused the Great Depression. In the future we may have to do exceptional things again if we face a shock that large," Geithner said in December, according to Romero. "You just don't know what's systemic and what's not until you know the nature of the shock."