By GRETCHEN MORGENSON

EVERY once in a while, Congress awakens from its lobbyist-induced torpor, realizes that the masses are cranky and sets out to appease them. Such a moment occurred last week when lawmakers finally got the message that Main Street is disgusted with Wall Street and wants them to do something about it.

Financial reform, which had been stumbling along, suddenly got traction. Bills and proposals began flying around Capitol Hill, and President Obama chided the bankers in an appearance in New York.

Unfortunately, the leading proposals would do little to cure the epidemic unleashed on American taxpayers by the lords of finance and their bailout partners. The central problem is that neither the Senate nor House bills would chop down big banks to a more manageable and less threatening size. The bills also don’t eliminate the prospect of future bailouts of interconnected and powerful companies.

Too big to fail is alive and well, alas. Indeed, several aspects of the legislative proposals sanction and codify the special status conferred on institutions that are seen as systemically important. Instead of reducing the number of behemoth firms assigned this special status, the bills would encourage smaller companies to grow large and dangerous so that they, too, could have a seat at the bailout buffet.

Here’s an example of this special treatment: Both bills would establish a specific process to resolve big-bank failures. Smaller institutions, by contrast, would be allowed to go bankrupt without a new resolution scheme.

This special resolution system is not only unfair; it also sends a pernicious signal to the market about large and intertwined institutions. The message is this: Subject as they will be to a newly codified “resolution authority,” these institutions and their investors and lenders can expect to be rescued if they get into trouble.

This perception delivers lucrative advantages to these institutions. The main perquisite is lower borrowing costs, a result of lenders’ assumptions that the giants are less risky because they will be in line for government assistance if they become imperiled. Think Fannie Mae and Freddie Mac. And remember all those folks on Capitol Hill and elsewhere who assured taxpayers that we would never lose a dime on those companies?

It is disappointing that none of the current proposals call for breaking up institutions that are now too big or on their way there. Such is the view of Richard W. Fisher, president of the Federal Reserve Bank of Dallas.

“The social costs associated with these big financial institutions are much greater than any benefits they may provide,” Mr. Fisher said in an interview last week. “We need to find some international convention to limit their size.”

Limiting their leverage is another way to begin defanging these monsters, Mr. Fisher said. But he concedes that there is little will to do either. “It takes an enormous amount of political courage to say we are going to limit size and limit leverage,” he said. “But to me it makes the ultimate sense. The misuse of leverage is always the root cause of every financial crisis.”

The idea for a special resolution authority appears to rest on the belief that large, troubled institutions cannot be allowed to go bankrupt because their collapse will cause other entities to fail. Again, this seems exactly backward. If imperiled banks are too large and interconnected to go through our nation’s time-honored bankruptcy process, then they are too big to exist.

A TWO-TIERED system, where large entities are more equal than others, is also deeply unfair. Smaller banks cannot hope to compete with institutions that have significant cost advantages. “Why should you have a small group of institutions get an advantage simply because they have grown too large?” Mr. Fisher asked. “It’s un-American; it’s not what makes this country great.”

Indeed, removing the subsidies awarded to big banks would give Main Street lenders — most of which did not bring the financial system to its knees — a chance to win market share.

Mr. Fisher also disputes the view often taken by defenders of the status quo that financial institutions hoping to compete for business in huge global markets must be gigantic. “There are those who say that America has to have the largest financial institutions to be an international player,” he said. “But I don’t think that’s a strong argument. Good companies will always find bankers and investors.”

Edward Kane, a finance professor at Boston College and an authority on financial institutions and regulators, said that it was not surprising that substantive changes for both groups are not on the table. After all, powerful banks want to maintain their ability to privatize gains and socialize losses.

“To understand why defects in insolvency detection and resolution persist, analysts must acknowledge that large financial institutions invest in building and exercising political clout,” Mr. Kane writes in an article, titled “Defining and Controlling Systemic Risk,” that he is scheduled to present next month at a Federal Reserve conference.

But regulators, eager to avoid being blamed for missteps in oversight, also have an interest in the status quo, Mr. Kane argues. “As in a long-running poker game in which one player (here, the taxpayer) is a perennial and relatively clueless loser,” he writes, “other players see little reason to disturb the equilibrium.”

It is a shame that Congress is moving forward with financial regulations that do not eliminate the heads-bankers-win, tails-taxpayers-lose mentality that has driven most of the bailouts during this sorry episode. Companies that are too mighty to fail must be broken up. And incentives in the nation’s regulatory system that reward size with subsidies should not be enshrined into law. They should be eliminated.

Only then will America be safe from toxic banking practices and the burdensome rescues they require.



http://www.nytimes.com/2010/04/25/bu...nmWEde4vG7oLDQ