Senate Faces Showdown over “Too Big to Fail” Controversy
Business + Economy

Senate Faces Showdown over “Too Big to Fail” Controversy

In the wake of a major government fraud case against Goldman Sachs, the Obama administration and Senate Democrats are poised to forge a consensus this week on a sweeping overhaul of financial regulations. Treasury Secretary Timothy F. Geithner declared yesterday on NBC's "Meet the Press" that Democrats and some Republicans "are very close on this," and suggested that the Securities and Exchange Commission's civil suit last week, charging Goldman Sachs with selling investors a subprime mortgage investment designed to lose value, might provide added impetus for the financial regulatory legislation.

As Senate leaders and the White House attempt to push legislation that responds to the lessons of the global financial crisis, perhaps the single most important question will be whether they can successfully address the potential damage from financial institutions deemed "too big to fail."

It was the collapse of Lehman Brothers and near-death of American International Group (AIG) and other major banks and institutions that prompted unprecedented government intervention in the financial markets in the fall of 2008. As Senate negotiators and the administration exchange ideas this week on the final shape of a financial regulatory reform package, Democrats and Republicans agree on the essential goal of preventing future emergency bailouts, but they disagree markedly on the methods.

Senate Banking Committee Chairman Christopher J. Dodd, D-Conn., backed by the White House and most of his party, proposes imposing tougher rules on the largest financial companies and charging them fees to pay for liquidating any mammoth firm that runs into trouble in the future. “This bill is tighter than you can imagine when it comes to the issue of taxpayers ever again bailing out failed institutions or getting that implicit government guarantee,” Dodd told MSNBC last week. “If you’re a shareholder, you lose money. If you’re management, you get fired. This bill absolutely shuts that door once and for all.”

But Republicans criticize this as "baking into the law" a recipe for bailouts and creating a $50 billion “slush fund” that will encourage big firms to take excessive risks and lead to even more failures. Senate Minority Leader Mitch McConnell, R-Ky., called the Democratic bill “seriously flawed” and warned that it "institutionalizes” taxpayer-funded bailouts. All 41 Republican senators signed a letter, released Friday, opposing the bill as written.

Because that proposed $50 billion bank liquidation fund has become such a serious sticking point, the Obama administration is urging Senate Democrats to drop it from their bill. The administration instead wants the costs of liquidation to be paid by the financial industry after a firm has failed and has been dismantled. Treasury has recouped a third of the $545 billion it invested to help rescue U.S. financial institutions and in some cases has reaped substantial returns on its investments.

Martin Baily, a senior fellow at the Brookings Institution, said that while almost nobody wants to perpetuate the “too big to fail” concept, “we do need the flexibility and some temporary funding to deal with these large global institutions if there is a brewing financial crisis.

"This is going to be a very contentious issue and both sides are going to say you're in the pocket of the financial sector," Baily said.

Indeed, financial lobbyists are working frantically to influence the shape of legislation, spending $1.4 million a day, according to one analysis of figures compiled by

  Senate Democratic and GOP leaders and President Obama met last Wednesday to discuss the issue, and Senate Majority Leader Harry Reid, D-Nev., expects to bring the bill to the floor for a vote as early as this week. Democrats have the momentum and public support to pass the measure, analysts say, but lawmakers on both sides maintain that they want a bipartisan bill.

"I will be stunned if we do not reach a bipartisan agreement," Sen. Bob Corker of Tennessee, a key Republican negotiator on regulatory reform, told ABC's "Good Morning America" last week. With midterm elections looming this fall, no lawmaker wants to be seen as opposing reforms to a flawed regulatory system that failed to stop the housing bubble, mortgage abuses and global financial crisis. Over the weekend, President Obama stepped up pressure for passage of the regulatory reform legislation, which includes creation of a new consumer protection authority. He accused McConnell of "cynical and deceptive" attacks on the measure.

At the heart of the debate is a thorny question: Is it even possible to abolish "too big to fail" institutions? Or are periodic financial crises a necessary evil in our free market system?

Regardless of whether one believes the government should let large firms collapse, investors assume that there will be a bailout of any major institution that could trigger a cascade of connected bank failures, said David Min, associate director for financial markets policy at the Center for American Progress. Ignoring this reality is like burying your head in the sand, Min said. 

The pending Senate legislation takes as a given that some firms are too big to fail, and provides an orderly process for a council of regulators to identify looming failures and liquidate the firms in question. The legislation would empower regulators to identify systemically risky institutions. Tougher leverage and capital requirements would be imposed on the biggest institutions to discourage banks and other firms from growing too big, as would a fee imposed to help pay for unwinding any tottering "too big to fail" firm.

"We believe if an institution makes bad economic decisions it should be allowed to fail," said Scott Talbott, senior vice president of the Financial Services Roundtable, which represents global financial companies. "The key issue is to provide a soft landing to that failure to minimize the disruption to its counterparties and the rest of the market."

A more extreme position, suggested by Dallas Federal Reserve Bank President Richard Fisher on Wednesday, is to break up the biggest financial institutions so they can no longer threaten the global markets. 

Policymakers should focus on leverage and capital ratios, not size alone, in evaluating the risks a single institution could pose to the financial system, said Barbara Novick, vice chairman of BlackRock, a global investment company.  "What caused our problem was hidden leverage, or complicated structures that included leverage that weren't factored in and not having enough capital to weather the storm," Novick said.

The financial industry wants to kill, or lower, the proposed fee on large firms, arguing against funding the liquidation of "too big to fail" firms in advance of a crisis. Taking that money out of the economy means it can't be used to create jobs and could lead to misuse, said Tom Quaadman, president of the U.S. Chamber of Commerce's Center for Capital Markets Competitiveness.

"You have a pot of money that is supposed to be used to cover the costs of unwinding a systemically important institution," said Peter Garuccio, spokesman for the American Bankers Association. "That presents a great temptation to use it earlier than necessary or for reasons that are not in keeping with the intent."

Policymakers cross ideological lines when it comes to advance funding of dissolutions. Treasury Secretary Timothy Geithner originally proposed paying to liquidate "too big to fail" firms after the fact, but in the face of criticism that it was a blank check for bailouts, the House financial reform legislation approved last year included an even larger prepaid fund than called for by the Senate.

It’s far from clear whether Senate Democratic and Republican negotiators can strike a compromise with time running out. If they fail, the Democrats could call a vote that forces lawmakers to choose between Wall Street and Main Street.

"It's a win-win for them," Min said. "The attitude among Democrats is that if Republicans want to vote against the most popular remaining issue, let them do it. They'd love to go into the elections with the Republicans having voted against financial reform."