As long as there are megabanks, there will be bailouts

The new administration will undoubtedly address needed reform of the problematic Dodd-Frank Act this year. Especially pressing is Dodd-Frank's Title II, known as the Orderly Liquidation Authority.

The OLA gives regulators the power to seize and liquidate failing "too big to fail" banks, attempting to eliminate taxpayer-funded bailouts while minimizing disruption of a collapse to the financial system. It adopts many of the Federal Deposit Insurance Corporation's methods used for small bank receiverships.

But critics have correctly noted that Title II has in fact institutionalized TBTF by creating formalized bailout procedures with dedicated taxpayer-supported funding.

GOP lawmakers are now focused on the proposed Financial Choice Act, a contender to replace the DFA. It contains new provisions to prevent future taxpayer-funded bailouts. The provisions include, among other things, a repeal of the OLA procedure, a reform of the bankruptcy laws as an alternative for winding down failing giants, limits on Federal Reserve emergency lending power and repeal of the FDIC's authority to guarantee bank obligations.

The problem with these provisions is they are the wrong solution to the right problem. Attempting to eliminate bailouts while TBTF banks exist is dangerously delusional. Despite DFA's capital and liquidity increase efforts, research shows investors perceive the big six banks — Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley and Wells Fargo — as no safer than they were before the crisis.

Banks simply have insufficient capital to cover losses created by forced sales of assets at fire-sale prices during a crisis. Among the post-crisis reforms was the Fed's Total Loss-Absorbing Capacity rule, which requires firms to have enough capital and long-term debt to support a resolution. But the modest capital levels imposed by the rule are unlikely to cover losses in a failure.

This leaves the question of what to do should one or more TBTF banks experience financial difficulty during the next crisis. Reform efforts relying on bankruptcy law, like the Choice Act, represent a questionable untested leap of faith with a huge downside should it fail to work. The problem is not with the bankruptcy code, but with trying to apply it to TBTF institutions during a crisis. Their very size would clog the system. For example, Lehman Brothers, a midsize investment bank that filed for bankruptcy in 2008, took years to resolve.

Trying to resolve one, or more, much larger and more complex TBTF banks during a crisis without a bailout would be like trying to change a flat tire while the car is still moving. This is why "no more bailouts" laws lack market credibility. Investors recognize no government would or should allow a TBTF bank to fail during a crisis.

Bailouts are merely the symptom of the boarder problem of having banks too big to resolve safely. Under the current set of choices, policymakers face a difficult balancing act trying to ensure the safety of the banking system while avoiding taxpayer-funded bank bailouts. It may only be possible to satisfy one of those interests at any one time.

Yet there may be a more effective reform path in considering structural alternatives to the banking system: either reducing the size of TBTF banks so they can more safely fail, or regulate them as utilities to prevent their failure.

There are no easy, quick fixes. If there were, they would have been tried already. Reform efforts must guard against creating a false sense of security leading potentially to disastrous governmental inaction during a crisis. The idea that orderly liquidation under Dodd-Frank, reforming the bankruptcy code or some other means will fix the TBTF problem is a myth.

Whether you like bailouts is irrelevant to the TBTF issue. If these institutions exist, then bailouts are required. The only way to end bailouts is to eliminate TBTF-sized institutions.

Address the problem, not the symptom, to avoid a cure worse than the disease.

J.V. Rizzi is a banking industry consultant and investor. The views expressed are his own.