WASHINGTON — A key point of contention in the Senate regulatory reform bill comes down to a critical question: How much flexibility should the government have when a systemically important firm falters?

Critics charge that the bill gives the Federal Deposit Insurance Corp. too much latitude, including the option to bail out creditors and use taxpayer money to prop up a big bank.

"The present Dodd bill doesn't go nearly far enough to end too big to fail," said Sen. David Vitter, R-La., a member of the banking panel. "When you look at the exact language, there is a lot broader authority for the FDIC … . I think in a crisis the FDIC could just prop up a company."

But supporters, including the Treasury Department and the FDIC, claim some flexibility is necessary to prevent a major failure from endangering the economy.

"The ultimate resolution authority needs to have some flexibility because you can't ever predict what challenges are going to face our country, the Federal Reserve or the FDIC in the future" said Robert Hartheimer, a former FDIC director of resolutions who now works for Promontory Financial Group. "You need to give the FDIC authority to deal with creditors, particularly because diversified financial holding companies' capital structures are complicated with both equity and unsecured debt."

The issue is one of the key arguments Republicans are using to oppose the bill by Senate Banking Committee Chairman Chris Dodd, which could come to a floor vote shortly after lawmakers return from recess on April 12.

Dodd has already made several changes to constrain how resolution powers would be used. Under the original reform proposal unveiled last June by the Obama administration, the FDIC could have provided open bank assistance to a large, systemically important firm or put the company into a conservatorship instead of a receivership.

But the draft that the Senate Banking Committee approved last week would not give the agency such leeway, requiring receivership for a systemically important company. The Dodd bill even clarified that the FDIC "shall" liquidate a firm, removing earlier legislative language that said it "may" do so.

"These authorities are much more constrained than the original proposal," said a Treasury official who spoke on condition of anonymity. "There is now a clear statutory requirement that a firm be put in liquidation; there is no conservatorship; there is no open bank assistance available."

Under the Dodd bill, bankruptcy would still be used for the vast majority of bank holding companies. But the contingent capital of a systemically significant firm that was insolvent would have to be converted to equity; its management would be fired, and its shareholders and unsecured creditors would have to absorb the first loss. The bill lets the FDIC treat "creditors similarly situated" differently in order to maximize the value of assets and sale proceeds or to minimize losses. Critics have interpreted this to mean that unsecured creditors might be bailed out.

Peter Wallison, an Arthur F. Burns Fellow in financial policy studies at the American Enterprise Institute, said this would continue to give large banks a funding advantage over smaller banks and the concept of "too big to fail" would endure. The bill "fails to recognize that the most important fact is whether the creditors get a better deal from a government rescue than from a straight bankruptcy," he said. "If they see this as a possibility, then they will prefer to lend to big companies that might be rescued by government (and not be sent to bankruptcy) than to small ones. This will give big companies large competitive advantages over small ones."

Vitter favors adding a stricter timetable to the bill to ensure that the FDIC does not operate a bridge bank or take other steps to keep an institution running for a long period. He also wants to ensure unsecured creditors are always subject to losses.

"A time frame needs to be mandated so that this can't just go on and on," Vitter said. "All of this needs to be required because, if there is great flexibility, I think a lot of regulators or agencies in a crisis will just go on and on with support. We saw that in the last year and a half, clearly, that people who should have taken deep losses in many cases got 100 cents on the dollar. It was ridiculous."

But the Obama administration argues that the FDIC must have some wiggle room to ensure the economy is not harmed when a large bank collapses.

Andrew Gray, a spokesman for the FDIC, said Tuesday that the agency's power to treat creditors differently is based on its resolution authority over banks in current law. "The flexibility built into the resolution authority of the Dodd bill mirrors current statutory authority in the FDIC's resolution process as governed by the FDI Act," he said. "It is designed to allow us to package and market the failed institution in a way that maximizes returns."

Gray said creditors would still take a loss.

"Creditors absorb losses under a strict priority system," he said. "It's difficult to make the argument that the FDIC's current resolution process results in bailouts."

An aide to Dodd said the bill would not allow any bailout.

"This bill ends too big to fail bailouts — period," she said. "We are happy to work with senators and their staff to address their concerns and clear up any misconceptions they may have about the bill."

The Treasury has argued that a certain amount of flexibility is necessary to prevent the government from repeating the American International Group experience — exactly the case raised by Vitter. When AIG was taken over, the government felt it legally needed to treat all creditors the same, either choosing to bail them out or let the company go into bankruptcy (In the end, AIG's counterparties were made whole.)

"From my perspective it creates a framework which is missing today and allows for an experienced agency such as the FDIC to come up with a plan," said Hartheimer. "You will never be able to legislate for exactly what disaster will occur in the future, but you have to get close, which I think this bill does."

Under the Dodd bill, the FDIC could sell off a holding company's assets in whole or in part and transfer salvageable parts to a bridge bank. The Dodd bill limits the use of a bridge company to five years.

Dean Baker, the co-director of the Center for Economic and Policy Research, said Republicans need to try a different tack if they are serious about ending "too big to fail." He said that, as long as there are megabanks, the government needs some leeway in unwinding them. "The problem is, you have this whole chain where they owe money to other banks and other financial institutions," he said. "I'm sure there are enough loopholes at the end of the day that you can find ways around most of the restrictions in the Dodd bill, and it may not be a bad thing if you are faced with a banking collapse — then you probably want your regulators to have some room."

He said the only real way to fix the problem is to limit the size of institutions. "That's what I find incoherent with the Republican position," Baker said. "That they are absolutely right that if you want to nail everything down and make sure that taxpayers are not going to be put on the hook again, this bill doesn't do it. But on the other hand, you can't do that as long as you have really large institutions, so those two have to go together."

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.