Will financial reform end big bank bailouts?

Lawmakers are pledging to end bailouts in the financial reform bill that the Senate is considering now. But many experts say bank bailouts can and will occur again.

"Orderly liquidation." The words appear prominently in financial reform bills to overhaul the way the US government will regulate America's financial system in the aftermath of a near-meltdown in late 2008.

The idea is that if a large firm gets into trouble in the future, it can't expect any generous taxpayer bailouts, as happened at American International Group (AIG) and other firms. Rather, if a large bank takes big risks that go awry, regulators will preside over its dismemberment with steely resolve.

That, at least, is the simple message lawmakers say they want to send with legislation that's moving into its second week of Senate floor debate.

President Obama, too, has been pledging an end to bailouts. "That's what this reform does," he said recently of the Senate bill.

But regulating the vast financial system is anything but simple, and many experts say bank bailouts can and will occur again, even if Mr. Obama ends up signing a reform bill by midyear.

A basic problem lies in that phrase, "orderly liquidation." In the heat of a financial crisis, that's something very hard to do with a large and interconnected financial firm on the brink of failure.

Orderly liquidation is exactly what did not occur in 2008. During the crisis, most tottering firms – from sprawling Citigroup to insurance giant AIG – received some form of government backing. Then, when Lehman Brothers didn't get a government bailout, credit markets quickly spiraled down toward what could have become a broad and catastrophic collapse. To restore stability, Congress held its nose and created a $700 billion rescue fund.

For regulators and Congress, propping up the economy trumped a distaste for bailouts.

"In a crisis, they'll do the same thing again," predicts Peter Nigro, a finance expert at Bryant University in Smithfield, R.I.

No outright ban on bailouts

The bills in the House (already passed) and Senate (in progress) include tough language designed to make bailouts both less common and less generous in the future.

But some critics of the legislation say it will fail to end bailouts, and that this is a bad thing. The real problem during 2008, they say, was not that Lehman wasn't rescued but that investors had come to expect government aid rather than insisting upon caution and discipline in financial activities. The proposed bills will perpetuate this problem, these critics warn.

At the other end of the spectrum, some economists say the opposite: The law may succeed at preventing bailouts – and that this is a bad thing. You don't want to tie regulators' hands in a crisis or possibly make a crisis worse by moving to dismantle large firms.

A middle view is that the legislation strikes a reasonable balance. These financial experts say the bill puts investors in failing firms on notice that they will bear losses when a firm gets in trouble, while also giving regulators the flexibility to contain any economic ripple effects from a firm's failure.

"A lot of the discussion has been overly simplistic," says Dean Baker of the liberal Center for Economic Policy and Research in Washington. For all the talk about the need to end bailouts, he says, the bills still give "relatively open-ended authority" to government officials in a crisis. "I'm not upset that they have that option," he says.

In the 2008 crisis, the recession might have become much worse without the safety net provided by that $700 billion Troubled Asset Relief Program and extraordinary Federal Reserve lending activities, for example.

In this light, the question of "bailouts" versus "liquidation" is not just one of fairness to taxpayers. The larger question – the issue that's ­fueling the drive for financial reform – is how to protect the economy from financial crises. The economy needs a healthy financial industry, not one that's prone to booms and busts.

Most of the financial reform package in Congress consists of provisions intended to prevent another financial crisis, such as tighter oversight of banks. But the second level of reform – focused on how to deal with large failing firms – ties back to the first issue of crisis prevention.

Bailouts create what's called "moral hazard," because government aid saves risk-takers from the consequences of their risky behavior. That can encourage future bad behavior, setting the stage for another crisis.

How tough is too tough?

The debate on the Senate floor is not all about election-year political posturing and the influence of bank-lobby dollars – though there's plenty of that. It's also that these are tough regulatory challenges to resolve.

"There are elements of flexibility [in the bill], but there is a clear effort to force these firms toward ­liquidation," worries Douglas Elliott, a Brookings Institution expert who has worked on Wall Street.

The Senate bill makes the task sound deceptively easy: A large firm should be liquidated, it says, "in a manner that mitigates such risk [to the economy] and minimizes moral hazard." But to achieve those twin goals may require both new tools and new fortitude from regulators.

In Mr. Elliott's view, the Senate bill would limit regulators' options more than does the House bill approved in December.

Both bills use the "orderly liquidation" phrase. Both seek to make a bank's managers and creditors face consequences if the firm fails. The Senate bill, for example, says "management responsible for the condition of the financial company will not be retained."

The House bill calls for firms to draw up so-called funeral plans in case of failure, but it also includes language that enables the government to make loans to a failing firm, buy assets from the firm, or guarantee its debts. Senate Republicans complained in a recent report that the Dodd bill also goes easy on failing firms.

"As the receiver, the FDIC [Federal Deposit Insurance Corp.], with the consent of the Secretary of the Treasury, is explicitly authorized to pay creditors and shareholders of the company more than they would be entitled to receive in bankruptcy," they wrote on April 30.

Regardless of what the bills say about the resolution of a failing firm, they also authorize the FDIC and the Federal Reserve to provide broad support to the financial system – such as lending money or guaranteeing debts – much as they did in 2008.

In theory, the idea is to keep healthy firms from being caught in the vortex of a crisis, with asset prices being pushed downward in an investor panic. But if most banks have engaged in risky behavior, propping up "the system" is also bailing out bad actors.

In the debate over tighter regulation, complex issues can be obscured by debates that may be largely semantic. Case in point: A politically important compromise in the Senate in recent days has been to remove what Republican critics called a $50 billion "bailout fund."

Republicans' concern was that the fund's existence would make firms conclude that more bailouts are on the way. A fair point, but other provisions also may encourage banks to expect aid.

With or without the fund, the reform bills call for the industry to bear any direct bailout costs. And for taxpayers and other Americans, the real cost of a crisis is not bailouts, but recession and joblessness.

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