Why We Need Plans To Break Up Too-Big-to-Fail Banks

(MoneyWatch)  Editor's Note: Economist Mark Thoma is guest-blogging for The Macro View this week.
There are several proposals for financial reform with the House, Senate, and White House, each with different ideas about what needs to be changed to make the financial system more stable. However, one element that is common across proposals is to require that regulators have plans for the orderly dissolution of so-called too-big-to-fail institutions.

The ability to force large financial firms into bankruptcy without causing a financial market panic is an essential component of financial reform. The Fed and the Treasury have been criticized for their treatment of Bear Stearns, Lehman Brothers, and AIG among others. The policies that were implemented--save Bear Stearns, don't save Lehman, save AIG--appeared ad hoc. The reason for this is that the regulatory authorities did not have plans ready for dissolving troubled but systemically important firms, and even if they had, it's not clear that regulators had the legal authority they needed to force firms into bankruptcy. Without these things, regulators were forced to scramble for second best solutions.

When ordinary banks get into trouble, the well-established procedure is for regulators to take control of the banks, separate the good financial assets from the bad assets, then repackage the good assets and sell the bank back to the public. This process has been used frequently during the crisis to dissolve troubled banks.

Unfortunately, the laws and regulations that do exist were designed for the traditional banking system, not the more complex modern system, and regulators did not have plans nor the authority to dissolve larger, non-traditional banks like Lehman Brothers in the same way. The consequence was that the hands of regulators and policymakers were tied with respect to how they could respond to the crisis, and their attempts to find other ways to stabilize the system only added uncertainty to financial markets at a time when that was the last thing the markets needed.

Giving regulators the authority they need to dissolve large banks and requiring that they have plans ready to do so will give regulators and policymakers the tools they need to be ready the next time a crisis hits, but there is another advantage as well. When the crisis hit, regulators were forced to bailout large banks by essentially rewarding those who caused the crisis and the public is rightly upset about this. But with an orderly dissolution process in place, the losses can be allocated to the investors in the firm rather than taxpayers, and this should help with public acceptance of policies intended to stabilize financial markets.