[Corp. Watch] Corruption in America: Obama not too big to fail on finance reform

[Corporation Watch]

'Too Big to Fail' Survives Again

 Zombie banks, take comfort -- the zombie regulatory system lives on

(Fortune, June 25) -- The financial reform legislation hammered out [last] Friday morning on Capitol Hill closes many of the loopholes that led to the last crisis. But it stops well short of breaking the bad habit that has fed outlandish risk-taking for almost three decades: too big to fail.

	The reform bill does take strides toward a safer financial system. It will create a process for liquidating troubled financial firms, making another American International Group (AIG) less likely.

	It will boost oversight and transparency in the derivatives markets, making the crisis virus less contagious. It will charge a group of watchdogs with keeping an eye on systemic risk, which could keep Wall Street wagers from bubbling over.

	"They have made solid progress setting up a system to ensure financial calamities are less frequent," said Raj Date, who runs the Cambridge Winter Center, a non-profit financial policy consultant. "I would give it a 'B' over all."

	But to earn an 'A' grade, reformers in Congress and the administration would have had to go further. They could have confronted the biggest threats to the taxpayer-funded safety net, and tied their own hands to send the message they won't rush in to save the next big fool that gets in trouble.

	Instead, they produced a 1,500-page bill that leaves the biggest financial firms untouched and preserves bailout powers that were infamously exploited in 2008. So too big to fail, born in the 1984 bail-out of Continental Illinois and assailed ever since, staggers forward to the next crisis.

	"We need to reinforce the expectation that there will be no bail-outs," said Richard Carnell, a law professor at Fordham University who served in the Treasury Department under the Clinton administration. "But the approach used here entrenches the bailout expectations."

	Early on, the administration decided it wouldn't de-fang the biggest risk to financial stability: the giant banks whose size and appetite for risk makes many observers nervous, and the two loss-soaked mortgage insurers, Fannie Mae and Freddie Mac.

	A bill proposed in April by Democratic Senators Ted Kaufman of Delaware and Sherrod Brown of Ohio would have capped bank size and leverage, forcing behemoths such as Bank of America and JPMorgan Chase to slim down.

	Proponents say they believe the bill was gathering strength in a Congress animated by anti-Wall Street sentiment, but was defeated by the administration's opposition. Wall Street has been a huge campaign contributor, and the White House was loath to be seen supporting a bill that could cost high-paying jobs in a globally competitive industry.

	"We were very disappointed in the way that vote went down," said Heather Slavkin of the AFL-CIO, which supported the proposal to reduce the size of the largest banks.

	The new rules do give regulators tools to break up banks that pose a threat to the health of the financial system. But once a big financial firm runs into problems, the market inevitably gets nervous. But taking that kind of decisive action without either creating market upheaval or resorting to bail-outs "is very painful," said Date.

	"We still haven't instilled dramatically different debt-market discipline, and that's what we need to do," he said.

	To that end, it's distressing that one of the most infamous loopholes of the last crisis lives on: the rule that allows the Federal Reserve to lend to just about anyone if they threaten to upset the financial apple cart. The bill would have placed conditions on the Fed's use of that power, but Philadelphia Fed President Charles Plosser would go further.

	This week he proposed that the Fed relinquish that authority, which was used in a potentially costly taxpayer-backed 2008 sale of Bear Stearns to JPMorgan. Plosser said the Fed bail-outs undermined the [Constitutional separation of powers] by allowing [an arm of the executive branch] to make spending decisions that rightly belong with Congress.

	He called for an agreement that "would eliminate the ability of the Fed to engage in bail-outs of individual firms or sectors, and place such accountability where it rightly belongs — with the fiscal authorities." But regulators aren't exactly turning cartwheels about anything that would impair their flexibility when the next crisis comes.

	This, in turn, re-assures creditors who lend freely to giant firms, assuming they will be saved by the taxpayer bell should a calamity develop. The free flow of capital to too-big-to-fail firms lets them grow at the expense of smaller rivals.

	Until market overseers have a better grip on where the risks lie and show a willingness to act ruthlessly to stamp them out before they threaten the financial system as a whole, the mentality that fed the last bubble will live on.

	"Short-term stability is what's popular," said Carnell. "But you have to be willing to accept some near-term instability for the sake of systemic health, and there is no sign that they are."