How Not to Solve the Too Big to Fail Problem

(MoneyWatch)  Color economist Dean Baker unimpressed by a bill in Congress ostensibly aimed at cutting systemically risky financial companies down to size.

The measure, pushed by Sen. Barney Frank, D-Mass., chairman of the House Financial Services Committee, would require large financial institutions to pay a special fee to cover the cost of cleaning up a "too big to fail" company after it has collapsed.

The problem here resides in the word "after." Baker, head of the Center for Economic and Policy Research, says that bailing out a company whose failure imperils the financial system does nothing to deter it from acting recklessly. That's because it knows will be saved. Meanwhile, if a systemically risky institution really is on the verge of collapse, other financial players are likely to be under duress themselves and unable to come to the rescue. He lays out the following scenario:

To see how strange this is, suppose Citigroup or some other major bank collapsed, requiring $100 billion to pay off creditors. (We actually should not need a penny to pay off anyone other than insured depositors, if we were serious about the banks not being TBTF.) Either the failed bank was acting as a rogue institution, engaged in behavior that was far more reckless than its peer institutions, or it was doing the same thing as everyone else.

In the first case, would it make sense to tax the other large banks $100 billion because Citigroup acted recklessly? If the recklessness of one bank had led to its collapse in an environment where its competitors are sound, this would imply that there had been some serious failures of regulation. Why would we tax other large banks because the Fed, the FDIC, and/or other regulatory bodies had failed in their job?

Alternatively, suppose Citigroup collapses because it was doing the same thing as other banks, but was just slightly more reckless or unlucky. In this situation, which is similar to the one we faced last fall, all of the banks will be severely stressed. It would be impossible to hit them with a special fee. Could we have slapped a special fee on Citigroup and Bank of America last fall to have them cover the cost of the failure of Lehman? At the time, imposing any significant fee would have almost certainly pushed several more banks to insolvency.

Sorry for the long quote, but I couldn't have put it better myself. Again, solving the TBTF problem isn't a matter of keeping tighter rein on these behemoths, as U.K. financial regulators have come to realize. It's a matter of not letting them grow too big to begin with.