July 9, 2010 | Commentary on Financial Regulation

Reinforcing 'Too Big to Fail'

After many weeks of negotiations, Congress is close to passing its mammoth financial regulation bill. At more than 2,300 pages, the legislation represents the largest expansion of Washington's role in the financial industry since the Great Depression.

The goal: to minimize the chances that another financial crisis — and subsequent bailouts — will occur. The objective is a good one.

Unfortunately, this massive bill would do more to hurt consumers and the economy than help them. And rather than decrease the chances of another crisis or bailout, it would make them more likely to occur.

A closer look at some of the bill's features shows why.

Failing Financial Firms: The lack of an accepted process for closing down large financial institutions helped lead to the massive bailouts of 2008 and 2009. To address this, the financial regulation bill would create an "orderly liquidation" process, empowering regulators to seize and liquidate financial institutions they believe are in danger of failing.

But how would the regulators do this? Unlike a bankruptcy court, the bill grants regulators almost unlimited discretion, with limited appeal to courts. Such governmental discretion to seize private property is troubling.

Systemic Risk: The legislation sets up a 10-member Financial Stability Oversight Council — regulators who would monitor and address system-wide risks to the financial system. Among other things, the council would recommend that the Federal Reserve establish stricter capital, leverage and other rules for large, complex firms. This council could even force financial firms to sell off or close pieces of themselves.

Unfortunately, it's extremely difficult to detect systemic risk before a crisis has occurred. The council would serve mainly to shoulder blame for failing at an almost impossible task. Meanwhile, its huge powers are much more likely to destabilize the financial system by stifling innovative products while failing to detect dangers posed by existing ones.

New Consumer Bureau: The bill creates a new Bureau of Consumer Financial Protection with broad powers to regulate financial products and services. The idea is to protect consumers from unfair, deceptive and "abusive" practices. In reality, it would reduce available choices, even in cases where a consumer fully understands and accepts the costs and risks. For many, credit would become harder and more expensive to get.

The new agency would nominally be part of the Federal Reserve System, but it would have extraordinary autonomy. This autonomy would make it harder for existing regulators to ensure the safety and soundness of financial firms, as rules imposed by the new agency would conflict with that goal.

Debit Card Fees: The bill eliminates part of the fees retailers pay to certain credit-card companies for the use of debit cards. The part being eliminated goes to the financial institution that issues the card, and the loss of this income may cause certain issuers to either drop their cards or limit their availability. Fannie Mae and Freddie Mac: Despite much rhetoric about ending bailouts, the bill does nothing to address Fannie Mae and Freddie Mac, two of the largest recipients of federal bailout money. These two government-sponsored enterprises, now in federal receivership, helped fuel the housing bubble. When it popped, taxpayers found themselves on the hook for some $150 billion in bailout money. The failure to address their future is a serious error. It shows the hollowness of claims that this agreement will prevent future crises. This legislation is the wrong approach to fixing the financial industry.

Rather than end the "too big to fail" mindset, it reinforces it. Rather than end bailouts, it ignores the ongoing bailout of Fannie Mae and Freddie Mac. Rather than make the financial system safer, it reduces firms' ability to handle risk. And rather than help consumers, it raises their costs and reduces their choices. Congress should consider these problems carefully before rushing into final passage.

David C. John is senior research fellow in retirement security and financial institutions and James L. Gattuso is senior research fellow in regulatory policy in the Roe Institute for Economic Policy Studies at The Heritage Foundation.

About the Author

David C. John Senior Research Fellow in Retirement Security and Financial Institutions
Thomas A. Roe Institute for Economic Policy Studies

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

First appeared in the Pioneer Press