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Dean Baker

Dean Baker

Posted: November 2, 2009 08:33 PM

The House Financial Reform Bill: Don't Touch the Banks, Get a Smarter Fed

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Those who like banks that are too big to fail will love the latest financial reform proposals circulating in the US Congress. The bill put forward by Barney Frank, the chairman of the House finance committee, does little to change the current structure of the financial system.

The "too-big-to-fail" banks will be left in place, even bigger and less accountable than before. There will be nothing done to separate commercial and investment banking, so giants like Goldman Sachs will be free to speculate with money guaranteed by the Federal Deposit Insurance Corporation. The main difference is that the Federal Reserve Board will be granted even more power than it has now. And, we will tell the Fed to be smarter in the future, so that it doesn't make the same stupid mistakes that gave us the current crisis.

While we all want a smarter Fed, it is not clear that the bill before Congress will get us one, even though it will definitely give us a more powerful Fed. The new Fed will be able to decide which financial firms need to be put through a bankruptcy-like resolution process, paid for with a virtually unlimited amount of taxpayer dollars.

While the bill proposes that the cost of cleaning up after a big bank failure is supposed to be paid by other big banks, in fact the mechanism laid out in the bill virtually guarantees the opposite. Rather than raising a pool of money in advance from the big banks to cover the cost of a bailout, the bill proposes that large banks would be assessed a special fee only after a failure.

To see how strange this is, suppose Citigroup or some other major bank collapsed, requiring $100bn to pay off creditors. (We actually should not need a penny to pay off anyone other than insured depositors if we were serious about the banks not being too big to fail.) Either the failed bank was acting as a rogue institution, engaging in behaviour that was far more reckless than its peer institutions, or it was doing the same thing as everyone else.

In the first case, would it make sense to tax the other large banks $100bn because Citigroup acted recklessly? If the recklessness of one bank had led to its collapse in an environment where its competitors are sound, this would imply that there had been some serious failures of regulation. Why would we tax other large banks because the Fed, the FDIC and/or other regulatory bodies had failed in their job?

Alternatively, suppose Citigroup collapses because it was doing the same thing as other banks, but was just slightly more reckless or unlucky. In this situation, which is similar to the one we faced last fall, all of the banks would be severely stressed. It would be impossible to hit them with a special fee. Could we have slapped a special fee on Citigroup and Bank of America last autumn to have them cover the cost of the failure of Lehman Brothers? At the time, imposing any significant fee would have almost certainly pushed several more banks to insolvency.

The bottom line is that this bill is almost certain to leave the taxpayers holding the bag for future bailouts. Even worse, it does nothing about the moral hazard created by having institutions that are too big to fail. There is nothing in the bill to lead creditors to believe that the government will not make good on their loans to Goldman, JP Morgan and the other banking behemoths.

There is a large and growing consensus across the political spectrum for breaking up banks that are too big to fail. Advocates of this position include former Federal Reserve Board chairmen Paul Volcker and Alan Greenspan; Sheila Bair, the current head of the FDIC; and Simon Johnson, the former chief economist of the International Monetary Fund. There is no reason that we need financial institutions that are so big that they cannot be safely unwound without large commitments of government money.

The only people who seem to stand outside this consensus are those who hold power and are steering the process of financial reform. This is largely the crew whose regulatory failures gave us the current disaster. If they cannot learn from their mistakes then someone else will have to drive the reform process.