Bankrupting the Senate’s Too Big to Fail Agenda

How reforming the bankruptcy code is the best path to ending too-big-to-fail policy

Too big to fail is a costly, problematic policy. And there are viable solutions to fixing this disease.

But for a collection of political reasons, Washington is ignoring both the underlying problems and solutions. Sixteen months after the market meltdown of September 2008, not only does too big to fail remain, but the House has passed a bill that would set up a permanent bailout fund. Now the Senate has the opportunity to act on ideas put forth as real solutions to Wall Street’s size.

What would help President Obama fulfill his promise to end the policy of too big to fail?

First, instead of setting up a systemic risk regulator that would categorize firms into different risk categories with varying access to bailout funds, bankruptcy laws could be adjusted to allow for a more rapid wind down of banks and non-bank institutions.

U.S. bankruptcy law has a long history and well-established process for handling the failure of most businesses. The problem is that the current rules are too sluggish for handling the failure of a large institution like Lehman Brothers that has billions of dollars in outstanding contracts which need to be resolved quickly in order to avoid freezing up Wall Street.

Republicans in the House, despite their failure to reform Fannie Mae and Freddie Mac when they had power during the Bush years, put forth a reasonable framework for adjusting bankruptcy law to move a Lehman or Washington Mutual-like bankruptcy through the system quickly.

In addition to more rapid adjudication, objective standards defining when a firm is insolvent could be agreed upon so that shocks in the marketplace are limited. And policies could be put in place that clearly order the distribution of assets in honoring contracts with failed firms, with subordinated investments getting larger returns but the last pieces of a collection. The Treasury Department would also have to commit to honoring this structure, unlike their handling of debt and equity holders at firms bailed out during the crisis.

The second part of preventing too-big-to-fail without a bailout fund would be to reform the rating agency oligopoly. One reason that banks were able to grow so large was that rating agencies gave their securities triple-A ratings when the underlying assets were often wildly overestimated. A number of proposals have been put forth to change the rating agencies, including changing the model from institution payment for ratings to investor payment for ratings.

Whatever reform occurs, the most important thing is that rating agencies are held more accountable for their services. This would prevent the widespread practice of mislabeling securities, bonds, or other investments higher than they really are. Rating agency reform should also give banks more incentive to conduct their own due diligence. Having to examine investments closer before taking on the risk would be an extra layer that would help the process of holding bank risk taking.

Third, a single federal banking regulator could be established that would consolidate the banking oversight and consumer protection powers of the Federal Reserve, with the Office of Thrift Supervision, and Office of the Comptroller of the Currency. Putting all bank regulation under one roof would fill any regulatory gaps and be a healthy compromise with those who want a stand-alone Consumer Financial Protection Agency. This idea, which is being considered by the Senate, would also let the Fed focus on monetary policy, as it was intended to do.

Other ideas are out there too. One unique proposal that has caught some momentum was formulated by Arianna Huffington and Rob Johnson. The basic idea is to get all Americans to pull their money out of the big banks and put it into community banks. If the big banks can’t survive without deposits to leverage from then spreading the cash out would prevent banks from becoming too big to fail. According to Huffington and Johnson, this distribution of cash would create a productive, stable engine for growth.

But the whole reason that banks and other mortgage originators grew so rapidly in the first place was because they were able to provide a service that local banks couldn’t. In the 1980s, when it became clear that mortgage demand was about to explode, Wall Street figured out that community banks weren’t going to be able to handle the increased demand. In fact, we never would have experienced the growth we saw in housing in the first place without securitization.

Shifting all deposits into community banks would not mean going back to what we had before. Some local businesses might have access to loans, but there would certainly be plenty of entrepreneurs that wouldn’t have access to credit. A stable, productive market includes credit provided by both community banks that bet on more sure things, by larger banks that can bet on a wide range of risks, and by private equity firms that can take bigger risks.

The benefit of reforming bankruptcy laws, rating agency governance, and regulatory oversight is that it allows banks to operate at their own risk-large or small. If a bank wants to leverage 50-to-1, they can, but they would be responsible for the consequences of their errors, not the taxpayers.

Ending the policy of too big to fail isn’t as simple as the president promising no more bailouts, but that would be a good start. Ideally, Congressional reforms will make it clear to banking institutions-deposit-bearing and investment-managing alike-that they are responsible for their own risk taking. This would help restore a sense of prudence to Wall Street and be a boon the economy as a whole.