06/16/2010 04:45 pm ET Updated May 25, 2011

Charles Plosser, Philadelphia Fed Chief, Criticizes Financial Reform Bills, Says They Don't End 'Too Big To Fail'

A top Federal Reserve official reiterated his call Wednesday for a tougher approach to ending Too Big To Fail, arguing that the current pending legislation before Congress doesn't adequately address the "most important element in fixing our financial system."

Federal Reserve Bank of Philadelphia President Charles Plosser criticized proposals that leave too much discretion to regulators and political appointees -- as the legislation does -- because he feels that when the time comes for a failing TBTF bank to be dismantled and shut down, regulators will be reluctant to pull the trigger.

"I don't think we've got the Too-Big-To-Fail problem solved in this legislation, and that's the one I worry most about," the central bank official told a crowd of bankers, regulators and economists in New York. Organized by a group of 15 economists that comprise the Squam Lake Group, the meeting was held to discuss the group's views on reforming the financial system.

"In my view, the most important element in fixing our financial system is that we must end the notion that some financial firms are too big or too interconnected to fail," Plosser said. "If a firm's creditors believe that the government will rescue them in times of trouble, they will have little incentive to exert market discipline and discourage a firm from taking excessive risk.

"Eliminating too big to fail should be the first priority of any regulatory reform. This is easier said than done. As the crisis has taught us, when the systemic risks are perceived to be large -- and regulators are prone to see systemic risks under every rock -- they will be very reluctant to close down insolvent firms or impose losses on creditors.

"So how do we reduce these risks so that regulators can credibly commit to a policy of allowing financial companies to fail and not resort to rescues or bailouts?" he asked.

Plosser is one of at least four regional Fed presidents who have publicly said that the current pending legislation does not do enough to end Too Big To Fail. Richard Fisher of Dallas, Thomas Hoenig of Kansas City and James Bullard of St. Louis are the known dissenters.

The Obama administration and the Fed's Washington-based Board of Governors, meanwhile, publicly cheer the legislation, hailing it as the measure that will end TBTF.

"While Congress is likely to pass a regulatory reform bill in the coming weeks, this is certainly not the end of the process of regulatory reform," Plosser cautioned. "Regulators will need to work out many details left open by the legislation.

"And taking the longer view, I don't think that Congress's approach is necessarily the final word on designing a resolution mechanism that will end the problem of firms that are too big to fail."

Instead of relying on the approach advocated by the Obama administration, which was largely adopted by both the House and Senate, Plosser repeated his call for a new bankruptcy-like process to resolve large, complex financial firms on the verge of failure. Market participants need firm rules and procedures, he argued, echoing a view voiced by Hoenig. Relying on regulators won't be enough.

"[I]f we are to deal effectively with the too-big-to-fail problem, we must have a credible mechanism to deal with such failures," Plosser said. "[T]he resolution process should be as predictable as possible; regulatory authorities should not be able to use discretion to alter contractual claims in the resolution process.

"I believe a bankruptcy court with special procedures for financial institutions would be better equipped than a bank regulator to credibly dismantle large financial institutions without bailouts," he added.

And unlike current bankruptcy law, which exempts derivatives contracts from its normal procedures, Plosser thinks this new version of bankruptcy should include most derivative contracts.

"Arguably, this special treatment actually increased systemic risks during the recent crisis," Plosser said of the existing exemption of derivatives contracts from bankruptcy court.

Here's how:

"Sophisticated counterparties were encouraged to provide short-term repo funding, collateralized by securities that turned out to be very illiquid, such as various asset-backed securities," he said. Repos are repurchase agreements, which are transactions in which one party borrows cash using securities as collateral with a promise to buy back those securities at a later date.

"These creditors clearly perceived that they did not need to carefully monitor their borrowers' condition, in part, because they expected that they could seize collateral before other claimants," he said. "In turn, this created incentives for the borrowing firms to increase leverage, and increase their reliance on short-term funding, which increased fragility in the financial system."

Hence, he argues, "we should limit the special treatment in bankruptcy to a much smaller group of contracts, such as those repos secured by highly liquid collateral (cash or Treasuries)."

If that happens, then other types of short-term funding may become "more expensive and less pervasive," Plosser said. "In turn, our financial system might become a little less fragile. Not such a bad outcome."

As for the oft-repeated critique that the international coordination issues involved in putting a failing TBTF bank through bankruptcy, Plosser acknowledged that while it's an "obstacle," it needn't lead to his plan being ignored.

"One possible solution is for global financial firms to declare a single jurisdiction under which bankruptcy would be administered," he said. While this would require coordination, "contrary to some claims, however, we don't really require a full harmonization of bankruptcy regimes across nations."

Rather, he said, "it is enough to seek agreement about the creation of a special regime for financial firms. International firms do go through bankruptcy now, so I don't see this as an insurmountable task."

These firm rules are all the more important because regulators likely won't be able to spot the next crisis, Plosser said, echoing a sentiment voiced by other policymakers.

"Discretionary supervision and regulation alone are not sufficient to prevent excessive risk-taking or prevent future crises," said Plosser.