GOP’s Financial Regulation Alternative Would End Too Big To Fail Policy

President Barack Obama unveiled his proposal to fix Wall Street regulation on June 17, 2009. If enacted, the plan would be the biggest expansion of federal regulation of the financial sector since the Great Depression. Congressional Republicans offered a counter plan today. Their alternative proposal includes several similar provisions, including establishing a board to oversee systemic risk, consolidating banking regulation, and reducing Federal Reserve independence (though, to be fair, the GOP doesn’t expand Fed authority anywhere close to what the Obama plan does). The GOP’s plan disappointingly does not address attacks on hedge funds and derivative contracts, and it expands the role of the Securities and Exchange Commission (SEC). However, the Republicans are chiefly focused on ending the policy of “too big to fail” and are opposed to bailouts, which is very encouraging. Here is a comparison of three key provisions that favor the GOP:

Oversight for Systemic Risk

Obama Plan: Establishes the Financial Services Oversight Council that will monitor the financial markets and determine if firms should be placed under newly designed “Tier 1” regulations; gives power to the Fed to enforce Council decisions and be responsible for stopping firms from becoming systemic risks.

GOP Plan: Establishes the Market Stability and Capital Adequacy Board to monitor the financial markets for potential systemic risks; only individual regulators would be authorized to act on a concern from the Board.

Commentary: Both proposals establish an oversight authority—the difference is how much power that body has. Both would be looking for systemic risks and pointing them out, but the Obama plan would explicitly classify firms as too big to fail, codifying one of the ambiguities that was part of the creating the crisis. This would permanently put taxpayers on the hook to bailout failing firms. The GOP’s Board could still create problems, but is more ideal because it has less teeth and authority.

Resolving Firms “Too Big to Fail”

Obama Plan: Creates a resolution authority to nationalize failing non-bank financial institutions in order to prevent systemic damage; funding for the resolution authority is yet to be determined by Congress; failing banks will still be protected by the FDIC.

GOP Plan: Amends bankruptcy laws to create new Chapter 14 bankruptcy proceedings for non-bank financial institutions that would build on Chapter 11 bankruptcy by expediting the hearing process; failing banks will still be protected by the FDIC.

Commentary: The real debate here is whether firms should be considered too big or interconnected to fail. The Obama plan believes this is unavoidable and seeks to create a system to handle non-bank firms that might need bailouts. This authority would have been used for AIG, Bear Stearns, or Morgan Stanley had they technically failed. The Chapter 14 proposal from the GOP believes that firms should be allowed to fail and then get resolved through the bankruptcy system.

Authority to Bailout Financial Institutions

Obama Plan: Allows the Fed to lend to financial institutions in extreme economic conditions with written permission from the Treasury Department.

GOP Plan: Repeals the Fed’s authority to lend to specific firms; distressed financial institutions would either be taken over by the FDIC or required to enter Chapter 14 bankruptcy.

Commentary: This is one of the starkest differences between the two plans. The Fed has lent or committed over $7.8 trillion since the start of the crisis, an excessive abusive of their authority. While the Obama plan does make the positive step of requiring Treasury to authorize future bailouts, taxpayers could still wind up supporting Wall Street failure. The GOP plan, in setting up Chapter 14 bankruptcy, sends a signal to the financial sector that no more firms will be bailed out.

There is a lot more to the regulation debate, and the GOP misses the mark on several points. But this issue of taxpayer’s being on the hook for failed institutions may be the most significant. Collectively, I’d take the GOP’s plan on these three and the Obama plan on most of the other issues—but only if I had to. The Consumer Financial Protection Agency is still a really bad idea.

Regulation reform is a foregone conclusion, at this point it is a matter of debating degress of change, like how many hedge funds to regulate. Hopefully, this alternative plan will have some influence on the debate and prevent a massive expansion of federal authority.