05/10/2012 04:41 pm ET Updated Jul 10, 2012

The SAFE Banking Act Will Do What Financial Regulators Thus Far Have Not

The federal government has yet to learn the overarching lesson of the 2008 financial crisis -- that too much risk concentrated in and between the largest financial institutions is a recipe for disaster. Preventing banks from becoming so large, complex, and interconnected that their failure would ravage the economy -- and thus formally ending the policy that any institution is "too big to fail" -- is the safest guarantee against a future "too big to fail"-driven financial crisis and resulting taxpayer bailout.

Public Citizen made this argument in January, when we petitioned the Federal Reserve and the Financial Stability Oversight Council to break up and reform the financial behemoth Bank of America so that it is smaller, simpler, and safer. Public Citizen relied on a relatively obscure provision in the Dodd-Frank Wall Street Reform and Consumer Protection Act, section 121, which grants financial regulators authority to mitigate the "grave threat" that an institution poses to U.S. financial stability. More than 30,000 Americans have echoed their support. We focused on Bank of America because publicly available information suggests that it is the riskiest and nearest to financial crisis. But the analysis that we offered would likely apply to other "too big to fail" banks as well.

Banks have only gotten larger and more complex in recent years. "Too big to fail" has really become "too bigger to fail." For example, the five largest U.S. banks -- JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, and Goldman Sachs -- held more than $8.5 trillion in assets at the end of 2011, equal to 56 percent of U.S. gross domestic product. That's a 13 percent increase from five years ago.

In the wake of the financial crisis and the passage of the Dodd-Frank Act, the apparent regulatory approach to dealing with "too big to fail" institutions has been dangerously short-sighted. Regulators don't appear willing to use all of the tools that they have at their disposal to safeguard financial stability. For example, the Federal Reserve Board's cavalier three-paragraph response to our detailed legal petition amounted to a thank you note, and suggests that the Fed is not taking seriously its responsibilities under the Dodd-Frank Act. Further, the Fed has allowed banks to pay dividends to their shareholders despite the fact that money paid to shareholders is gone forever, unavailable to buffer against loss when banks need it most. Stanford Professor Anat Admati has repeatedly pointed this out to regulators, but her calls have apparently fallen on deaf ears.

Any number of firms that have grown larger, more complex and interconnected could deteriorate rapidly at any time, triggering another crisis. For example, Bank of America is currently the riskiest bank according to an ongoing study by the NYU Stern School of Business, with JPMorgan Chase and Citigroup not far behind. Furthermore, Citigroup failed its annual stress test only two months ago. Even Wells Fargo, which until recently was widely considered stable, has engaged in accounting gimmicks by redirecting its loss reserves to "goose their earnings and hit analysts targets," according to prominent industry analyst Chris Whalen. There is also talk that Moody's is reviewing 17 major financial institutions for downgrades on their debt. Several banks are already not far from being rated junk status. Another downgrade could have disastrous consequences, requiring banks to post more collateral with their counter parties to back up their bets. It's unclear whether banks have the cash to meet the collateral calls, and what impact these actions will have on the banks' cost and availability of borrowing.

If financial regulators refuse to take decisive action to safeguard financial stability, then Congress must -- before another crisis materializes.

On Wednesday, Senator Sherrod Brown (D-OH) brought us one step closer toward this end by re-introducing the Safe, Accountable, Fair & Efficient (SAFE) Banking Act of 2012. This bill would impose strict limits on institutions' deposit and non-deposit liabilities and on their leverage, requiring them to hold considerably more capital to buffer against possible loss. As a result, the bill will shrink mega banks to more manageable sizes and reduce the concentration of risk in the financial system. Such institutions will be allowed to fail without endangering the financial system or economy. Banks and their shareholders and creditors will operate with more discipline, knowing that they cannot engage in excessive risks and then collect taxpayer funded bailouts.

President Obama has promised that, "Never again will the American taxpayer be held hostage by a bank that is too big to fail." Unfortunately, financial regulators have not yet given the public a strong indication that this is true. While there is still an opportunity for action -- and we urge regulators to take such action -- another method has just been introduced to fulfill his promise.