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Solving Everything but the Problem...   >>>

Solving Everything but the Problem

By PETER EAVIS



This is denial, not closure.



The House of Representatives has passed an ambitious-looking financial-overhaul bill. Meanwhile, Citigroup and Wells Fargo are following other major banks in paying back government investments made under the Troubled Asset Relief Program.



These and other developments suggest lawmakers and regulators are bringing an era of banking-sector instability to an end. But a chief cause of that havoc—a government willingness to bail out banks considered too big to fail— remains.



As a result, the U.S. economy could continue to suffer from a bloated financial sector, and taxpayers will continue to implicitly subsidize and possibly bail out large banks.



A small number of lenders now dominate the economy. The top four banks have combined assets of $7.4 trillion, or 56% of the U.S. banking sector's total. A decade ago, the top four's $2 trillion of assets accounted for 38% of the total. In the past 30 years, large banks have facilitated dramatic increases in leverage across the economy and stretched their own balance sheets. Financial-sector debt reached 118% of gross domestic product at the end of 2008, up from 18% in 1978.



Confronted by the banks' enormous size and their role in the crisis, lawmakers could have demanded smaller, simpler institutions. These would be much easier to regulate, and most important, they could fail without too much economic impact. Knowing the government could then let lenders collapse, bank creditors would think much harder about whom they lend to, reducing the chance of future credit bubbles.



Instead, the House bill deals with the big-bank problem simply by introducing more regulations, including tougher capital requirements for systemically important firms and potential limits on short-term debt.



Admittedly, in both the House and a parallel Senate bill, there are provisions that give the authorities the power to wind down a troublesome financial firm in such a way that its creditors get hurt. And the House bill aims to set up an industry-financed, $150 billion fund to pay for wind-downs.



But that sum is hardly likely to be big enough. After all, it is less than 20% of Bank of America's outstanding debt.



What's more, the bill contains language that gives the government the opportunity to bail out creditors of a seized bank if it feels that is "necessary for the purpose of financial stability." True, the bill does say any taxpayer funds shall be repaid ahead of other creditors in a wind-down. But the bill also says the government can choose to subordinate its claims on the bank to those of other creditors.



Psychologists would have a field day with these twists and turns. They reveal that regulators and lawmakers have identified the moral-hazard threat, but can't bring themselves to properly deal with it.



It would be a mildly diverting medical study if the well-being of the economy and political system weren't at risk.