Too Big to Fail Becoming Official Policy

President's Wall Street plan encourages banks to take risks, all but guarantees more bailouts

President Obama recently outlined his plan to fix the regulation of Wall Street and said it was time to “put an end to the idea that some firms are too big to fail.”

Amen.

But the president doesn’t need a new law or a new oversight committee, like the one he proposes, to end the concept of too big to fail.  He could, and should, simply make a speech declaring that from this day forward, any company, no matter how big or small, will be allowed to fail. If Bank of America or AIG or Chrysler goes bankrupt, so be it. Obama should unequivocally proclaim, “There will be no more bailouts. Period.”

If given, that speech would surely be the most popular thing Obama’s done since becoming president. Arianna Huffington and other liberals angry that 'crony' capitalists are getting corporate welfare would love it. Glenn Beck, Michelle Malkin, and fiscal conservatives who truly opposed President Bush’s $700 billion Troubled Asset Relief Program bailout would love it. Libertarians and independents would be ecstatic to see the end of a system that protects—and even rewards—businesses that make bad decisions.

Unfortunately, while Obama hints at ending “too big to fail” policies, his financial reforms actually continue to encourage the reckless financial behavior that helped get us into this mess.

The president is worried about system risk. If AIG or Citigroup fails, the whole financial system could be dragged down with them. As economist and historian Niall Ferguson points out, “By the end of 2007, 15 institutions with combined shareholder equity of $857 billion had total assets of $13.6 trillion and off-balance-sheet commitments of $5.8 trillion—a total leverage ratio of 23 to 1.”

But these massive banks don’t worry about being overleveraged because they know the government won’t let them fail. They can take all the risks they want because taxpayer money will be there to bail them out if their gambles don’t succeed. Rather than end this practice, the president’s proposal would label big firms as “Tier 1 Financial Holding Companies" that are subject to tougher rules, a new oversight committee and a bankruptcy insurance fund. The result of Obama's plan is actually a formalized too big to fail structure that encourages financial institutions to take on even more risk knowing they have taxpayer protection.  

Actually ending the policy of too big to fail would force financial institutions to self-correct their balance sheets or see a mass exodus of shareholders. Congress wouldn’t have to pass new Wall Street regulations or mandate new leverage ratios for banks because the clear message to investors would be simple: their money isn’t safe if it is sitting in overleveraged banks and companies.

There are also growing concerns that the nation’s biggest banks are just getting bigger, and thus are even less likely to be allowed to fail in the future.  CBS News reports that four institutions—JP Morgan Chase, Bank of America, Citigroup and Wells Fargo—now issue one out of every two mortgages and about two out of every three credit cards in the United States.

There’s nothing particularly worrying about those numbers—if you are willing to let those four companies go out of business. But, if taxpayers, via future bailouts, will be on the hook for half of the mortgages or two-thirds or the credit card debt in this country, we are in very bad shape.

President Obama is often at his best talking about personal responsibility. “It was a collective failure of responsibility in Washington, on Wall Street, and across America that led to the near-collapse of our financial system one year ago,” Obama said in his Wall Street speech. “So restoring a willingness to take responsibility—even when it's hard to do—is at the heart of what we must do.”

Responsibility, not expanded regulation, is exactly what is needed. If banks make risky loans to people who can’t pay them back—it is their responsibility. If financial firms get overleveraged and go out of business - it is their responsibility. If a carmaker makes decades of poor decisions and goes under—it is their responsibility.

There might be prudential changes necessary to the regulatory structure. But eliminating too big to fail bailouts from the government’s vocabulary entirely would be the best thing President Obama could do for Wall Street and Main Street.

Anthony Randazzo is a policy analyst at Reason Foundation and author of the new study Fixing the Regulation of Wall Street.

Anthony Randazzo is Director of Economic Research





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