TOO BIG TOO SOLVE ? / THE WALL STREET JOURNAL

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JUNE 15, 2009, 6:32 P.M. ET

Too Big to Solve?

By PETER EAVIS

Never again.

Catastrophes often give rise to ambitious new organizations aimed at preventing future debacles. The Obama administration is thinking big as it sets up a new financial regulatory regime to prevent nightmares like the collapse and bailout of American International Group.

But the Treasury's proposed reforms still appear to leave the door open to substantial taxpayer support of ailing financial behemoths. And for investors, this means the price of bank debt and equity could remain distorted for years.

The weakest Treasury proposal is one that gives the government the power to seize large financial firms it deems systemically dangerous.
The problem: The plans don't clearly set out how creditors and other stakeholders would be treated in a seizure. That means two big risks.

Instead of typical court-based bankruptcy proceedings, wind-down outcomes would be decided ad hoc by regulators. This could increase uncertainty, pushing up borrowing costs for banks.

An alternative risk is that creditors assume they'll always be protected, leading to an underpricing of credit to the financial sector. That's likely the greater risk, given that most policymakers seem to believe letting Lehman Brothers go bankrupt was a mistake.

The Treasury's plans don't deal with the size issue, either. There doesn't appear to be any blueprint for stopping firms becoming "too big" in the first place. This could prove a mistake after recent consolidation in the financial sector.

The "big four" account for an estimated 70% of all assets held by domestically-chartered U.S. banks. These same banks accounted for just under half at the end of 2000. And it isn't clear how big a firm has to be to become considered a systemic risk. Bear Stearns, with $395 billion in assets, was hardly a global giant, and yet authorities feared its collapse could damage the wider economy.

Of course, the Treasury is introducing other reforms it hopes will make financial firms safer overall, making size less of an issue. The most potent would be higher levels of regulatory capital. And a proposal for banks to retain exposure to their securitized products could work, particularly if they have to hold all parts of the structure, from the equity portion up to the triple-A slice.

It isn't clear Congress will sign off on all the Treasury's plans, particularly any regulatory structure that makes taxpayer support constantly available. Politicians may also balk at the fact that the Fed stands to amass more power under the new regime. Its failings as a bank regulator were serious; it was one of the overseers that allowed Citigroup's common equity ratios to plunge to dangerous lows. And its monetary policy arm's over-stimulative policy ahead of the credit boom arguably made it a stoker of systemic risk.

The too-big-to-fail problem may yet prove too big for the U.S. government.

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