Eighth in a series

WASHINGTON — "Too big to fail," once a debatable phenomenon, is now accepted public policy.

The Troubled Asset Relief Program, by injecting $125 billion into the nine largest financial firms, erased any doubt the government would allow a major institution to fail.

"There's no question it gave new life to an age-old debate around 'too big to fail,' " Diana Farrell, deputy director of the National Economic Council, said in an interview. "Some institutions get so large, complex, interconnected, leveraged or otherwise that they pose a risk to the system that it can't take."

One year later, "too big to fail" lies at the heart of the drive to revamp the regulatory system.

"What we got out of Tarp was the sad reality that we have a system that needs not just minor tweaking but fundamental reform, because the 'too big to fail' incentives are so real as to demonstrate that markets can no longer function without government support," said Josh Rosner, managing director of the research firm Graham Fisher & Co. "Until we address the disparity in treatment of big banks and small banks, we can't claim to have put the crisis behind us or have fixed the markets."

Looking back to last October, it is clear that the initial investments of capital into those nine companies solidified the notion that they were indeed "too big to fail." But Treasury officials reinforced that perception by rolling out a slew of programs that tended to benefit the largest institutions the most.

Certainly many firms took advantage of the federal guarantee of bank debt, unlimited deposit insurance for certain checking accounts and the Fed's multiple liquidity programs. But the largest firms were given more money, faced little to no hassle in receiving the funds and were stabilized by the perception that the federal government viewed them as a breed apart.

"The Tarp program … has predominantly supported the larger institutions," said Federal Deposit Insurance Corp. Chairman Sheila Bair.

Though the top nine banks almost immediately received $125 billion soon after Tarp began operation in Oct. 14, all other institutions had to apply for funds through a process that was opaque and chaotic. The Treasury said that only healthy institutions could receive the money, but at first had no definition for what "healthy" meant. Later, it said that was any bank that was "viable without Tarp."

The process of distributing the money was also unclear. In theory an institution's primary regulator would rule on an application and send a recommendation to the Treasury. At that point the Treasury would decide whether to give funds and how much. Though the Treasury claimed regulators were using a common set of criteria, they refused to make it public, and it was unclear if regulators were enforcing those standards in different ways.

From the very start, banks complained the system was unfair. Some banks had to wait for weeks or months to find out if they were receiving any money. Some smaller institutions like mutual thrifts didn't even have a way to apply.

Though Tarp has been in operation for over a year, many institutions are still waiting for their money. According to the Office of Thrift Supervision, 299 thrifts have applied for money, but only 56 have actually ever received it. A good chunk of them — 176 — withdrew their applications after lawmakers and others began clamoring to add more restrictions to the money. Still, there are plenty of thrifts in the pipeline. As of Aug. 14, 49 institutions were being reviewed by the OTS, while another 18 were under review by the Treasury.

(The OTS is the only regulator to release such data publicly, with the other banking agencies referring the matter to the Treasury, which cites confidentiality concerns in denying similar information.)

"While some big banks could just pick up the phone and get Tarp money, some community banks had to wait months," said Camden Fine, president of the Independent Community Bankers of America. "That just shows how unequal banks were treated. For most of the life of the program, community banks were discriminated against."

H. Rodgin Cohen, the chairman of Sullivan & Cromwell, said it was clear the Treasury did not have a concrete plan for how to help smaller institutions, especially ones that were struggling. He said the funds would have been better off shoring up troubled institutions.

"What Tarp did not provide was a program for the medium-sized and smaller banks that needed Tarp to be viable," Cohen said. "If it was my call I would certainly have created that and there is no reason it can't be done now. "

The idea that the money was only going to healthy banks also created additional problems. Banks that said they were applying for Tarp and did not receive money promptly were rumored to be in trouble, possibly even facing failure. If a bank received Tarp capital, it was a stamp of approval. If it didn't, it could help push an institution to failure.

"One of the overarching precedents it set in effect was you had the Treasury deciding which banks would survive and which would fail," Fine said. "You had the government decide the success and failure, not the free market, and that was a sea change. You had the banks that were 'too big to fail' and then you had the banks the government considered too small to save."

Adding more confusion was the government's subsequent decision to give Citigroup Inc. and Bank of America Corp. a second dose of funding. With Citi teetering, the government provided an extra $20 billion in November and agreed to guarantee $301 billion of its assets. It struck a similar deal with B of A in January. In both cases the Treasury's requirement that Tarp recipients be viable without government aid did not appear to apply.

As a result, it further undermined institutions that had received Tarp money. It was no longer clear who was receiving government capital and why.

"A mistake they made is they didn't distinguish the banks that were viable and the banks that were not," said Doug Faucette, a partner at Locke Lord Bissell & Liddell LLP. "They lumped in banks that were failing with banks that were not, so they gave the whole program a black eye."

Robert Clarke, a senior partner at Bracewell & Giuliani and a former comptroller of the currency, said it was "laughable" that the program would help only healthy banks.

"If you look at the condition of some of the large banks were in, I think a lot of people would question if they were healthy or not," he said.

Tarp also helped blur the lines between nonbanks and banks.

"Up until the point Tarp was done there was a growing awareness by the government and the Hill what the health of the commercial banking business was as opposed to the nonbanking industry," said Wayne Abernathy, executive director of financial institutions policy and regulatory affairs at the American Bankers Association. "All of those distinctions were confused all over again, because the recipients of Tarp were commercial banks and noncommercial banks."

The result was to solidify the notion of "too big to fail." Those nine institutions — Citi, B of A, Goldman Sachs, Morgan Stanley, JPMorgan Chase & Co., Wells Fargo & Co., Merrill Lynch & Co., State Street Corp. and Bank of New York Mellon Corp. — were thought to be on the list. The list was broadened a few months later, after the Obama administration announced it would "stress test" the 19 institutions with assets of more than $100 billion.

"We really nailed down 'too big to fail,' " said Kevin Jacques, a Boynton Murch chairman in finance at the Baldwin-Wallace College and former Treasury official. "That has very problematic implications for how we control these banks going forward. … It certainly could encourage riskier activities and it transfers the burden of identifying those things away from market supervisors and makes their job much harder."

Though the Bush administration suggested reforms in March 2008, the creation of Tarp ensured such a plan would be a priority topic for lawmakers this year.

President Obama's plan, unveiled June 17, is a myriad of moving parts, many of which appear tailored to address "too big to fail." It would give the FDIC the power to resolve bank holding companies, and allow the Treasury leeway to unwind other systemically risky companies. It would also give the Fed the power to supervise systemically important institutions and form an interagency council to advise the central bank on them (though it would have no authority of its own). The largest banks would face, at least in theory, higher capital and leverage requirements.

Of those proposals, Bair contends resolution powers are the most important and could effectively "end 'too big to fail.' "

"We would not have gotten to this point if we had a resolution mechanism that worked for very large institutions and intermediaries," she said.

She has also suggested that all systemically important institutions develop a "wind down" plan for how they could be dismantled in a crisis. European regulators have touted a similar idea to create a "living will" for critically important institutions.

But others say higher capital standards could have the biggest impact. "The most effective tool being discussed to deal with the 'too big to fail' issue is the progressively higher bank capital requirements," said Jaret Seiberg, a financial services policy analyst for Washington Research Group.

But many are unsure. Some lawmakers have said the reform plan is insufficient. New capital and leverage requirements would largely be left to the Treasury and other regulators to implement, and it is unclear how tough the requirements will be.

Even the matter of which institutions would be defined as systemically important is up in the air. The Obama plan would create Tier 1 financial holding companies — which many view as just another name for "too big to fail." Under the plan, any firm above $10 billion in assets would be required to submit information to the Fed to determine if they fit the bill. Some fear that labeling certain institutions as systemically important could encourage some companies to strive for the designation.

"The way we've gone here is to memorialize 'too big to fail,' " said Joe Mason, a finance professor at Louisiana State University. "This sets it in stone. "

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