April 22, 2010 | Commentary on Labor Regulation, Financial Regulation

Financial Reforms Go Too Far

As the debate over financial reform intensifies, it's easy to forget that there is a shared desire across the political spectrum to put an end to bailouts and to the idea that any firm should be too big to fail. Supporters of the plan now pending in the Senate argue that it would achieve these goals. It would not. In fact, it would institutionalize both.

Key to the Senate bill is a Financial Stability Oversight Council, made up of nine existing agencies, with broad regulatory power over companies it considers systemically important, including authority to order the firm to break itself up, stop selling certain products or even go out of business. The idea is to stop big companies from presenting a danger to the system as a whole when they get into trouble.

But the main problem faced by regulators isn't a lack of power. It's the difficulty in knowing when a systemic threat will appear, and what to do about it. Notably, none of the existing regulators foresaw the present crisis, and it's hard to see how this new council will prevent the next one.

However, identifying systemically important companies would have another effect. By singling out firms whose failure would present a danger to the financial system, regulators would in effect be telling investors that the government won't allow them to go under. These firms would enjoy an implicit federal guarantee, protected from the full consequences of risk-taking. "Too big to fail" would be institutionalized, not ended.

But it gets worse. Another part of the bill would authorize regulators to take over and close financial firms that they believe are failing. The regulators would have almost unfettered discretion to decide which ones to close, and when -- subject to minimal judicial review -- and broad authority to decide how to handle the affairs of the firm after it is seized. This power is similar to that now used by the Federal Deposit Insurance Corp. when it closes banks it insures.

But this proposal would extend that power to all financial firms, even if they aren't insured by the government -- even if they aren't banks at all. It's a dangerous expansion of government power.

At the same time, the bill would authorize regulators to pay compensation to creditors of companies being closed. In effect, they would be bailed out. Supporters of the Senate bill deny this, pointing out that the firm involved would be liquidated and stockholders barred from receiving support.

That's good, but the creditors -- including bondholders and derivative counterparties -- would be eligible for support. The consequence of this goes beyond the dollar cost of the bailout: By, in effect, insuring creditors from risk, a vital check on risk would be blunted.

The Senate bill is, nevertheless, right to focus on creating a way for large financial firms to fail, without undue harm to the rest of the economic system. But it should be done under set rules, under judicial supervision and without bailouts.

And there's already a system in place that meets this criteria: bankruptcy, the same system used to handle failure in the rest of the economy.

There is no reason, with perhaps a few modifications to take into account the special characteristics of large financial firms, it can't work here as well.

James Gattuso is a senior research fellow in regulatory and telecommunications for The Heritage Foundation. 

About the Author

James L. Gattuso Senior Research Fellow in Regulatory Policy
Thomas A. Roe Institute for Economic Policy Studies

First appeared in AOL News