WASHINGTON — The Obama administration's financial reform plan is being questioned on a fundamental basis: Will it resolve the problem of financial companies becoming "too big to fail"?
A wide swath of observers agree the administration is putting too much faith in regulators to police large institutions. What's more they recommend whatever tougher standards are to be applied to these companies should be nailed down now, not after the legislation is enacted.
"To have some clear targets would be desirable," said Dean Baker, the co-director of the Center for Economic and Policy Research. "Regulators always have some latitude and that's appropriate, but having ballpark levels … would be desired. We have to hold regulators accountable and if the wording is too vague it's very hard to hold them accountable."
Under the plan, regulators would decide which institutions are considered Tier 1 financial holding companies, and set new liquidity, leverage and capital requirements. But many argued regulators are being given too much leeway, and policymakers risk encouraging more institutions to become "too big to fail" if regulators are not stringent enough.
Many argue that Congress should set some minimum standards — similar to prompt corrective action requirements — that Tier 1 FHCs would face.
"Regulators need flexibility to set capital standards, but some minimums could be helpful," said Richard Spillenkothen, a former director of supervision at the Federal Reserve Board and now a partner at Deloitte and Touche. "You are never going to be able to … totally eliminate the problem, but you can reduce the scope of the problem, reduce the number of circumstances where you've got to support or bail out an organization."
Others said Congress could find more concrete ways to deal with the problem. The plan "doesn't contain anything that would lead you to believe that there would be aggressive action to break up large institutions or prevent their growing," said Alice Rivlin, a senior fellow with the Metropolitan Policy Program in Economic Studies at the Brookings Institution and a former Fed vice chairman. "It's not addressed at all."
The issue has been raised already by lawmakers and could represent a high hurdle for the Obama administration. "We have institutions that are 'too big to fail,' have we not failed already, since they create a systemic risk?" Sen. Robert Menendez, D-N.J., asked Treasury Secretary Tim Geithner during a hearing last week. "I saw the road you traveled here in trying to deal with that in terms of trying to increase capital requirements, but is that really sufficient to get to the heart" of the matter?
Supporters argue that in addition to new capital and leverage standards, a tough resolution regime would also curb "too big to fail." The Obama plan would let the Federal Deposit Insurance Corp. seize bank-centric Tier 1 FHCs, but let the Treasury decide the fate of nonbanks.
Such a step would go some distance in resolving the problem, some said.
"A sufficiently robust resolution mechanism for the largest institutions would go a long way to dealing with the systemic risk issue," said Eugene A. Ludwig, a former comptroller and chief executive of Promontory Financial Group. "If we have a mechanism for the resolution of the largest institutions that's convincing to the public and that can actually work, that would be a great stride. It is a very big part of what needs to be addressed in this regulatory reform effort, and happily it is being focused on."
But other observers said a resolution regime isn't enough.
"You are treating the symptom rather than the disease," said Anthony Plath, an associate Professor of Finance at University of North Carolina. "It creates a mechanism where companies that are like AIG or Citigroup can be in turn broken up. … Shouldn't we prevent companies from getting 'too big to fail' in the first place? Shouldn't we be proactive and structure a system in which we minimize the probability that these things happen? We have to have both. … The plan doesn't call for that at all."
Even determining which firms are Tier 1 FHCs could prove problematic if Congress does not provide additional guidance. The Obama plan said such firms would be decided on the basis of size and interconnectedness, but the latter is a hard standard to gauge. Would it include the 19 banks that were part of the stress test completed in May, which was solely determined by size? (All companies had more than $100 billion in assets.) Or would regulators create some measurement to determine how an institution's failure would reverberate through the system?
The plan also says such firms will be subject to prompt corrective action requirements, but it is unclear how regulators will choose to implement them.
Many observers worry that by designating any firm as a Tier 1 FHC that — no matter what restrictions are placed on the institution — it will encourage other companies to aspire to such status, exacerbating the "too big to fail" problem.
"What this does is it anoints certain institutions as being a protected class," Plath said. "As soon as you belong to that protected class, your cost of capital goes down, because in effect you have to become a quasi-public entity like a government-sponsored enterprise. All that does is create an environment where companies want to become, or there is an incentive to become, 'too big to fail.' "
While there have always been "too big to fail" institutions, until the financial crisis it was unclear exactly which ones were in that category. The Obama administration helped change that by putting those 19 financial holding companies through the stress tests — and pledging to come to the aid of any that failed it.
Though that solidified "too big to fail" for investors, at least temporarily, the restructuring plan would take that concept one step further. Once the Fed designated a firm as a Tier 1 financial holding company, investors would perceive it as "too big to fail," observers said. "It sort of enshrines 'too big to fail,' " said Andrew Jakabovics, an associate director of housing and economics with the Center for American Progress.
Joseph Mason, a finance professor at Louisiana State University, forecast a race by firms on the bubble to reach Tier 1 status. "It gives incentives for an institution to get over that hump and become 'too big to fail,' " he said. "
Administration officials have acknowledged the plan does not solve "too big to fail," but they say they are trying to discourage it. "Requiring a systemically important firm to hold higher levels of capital than its nonsystemic competitors imposes a tax on the risk of the firm," said Andrew Williams, a Treasury spokesman. "At the same time, it bolsters resources of the firm to support those risks."
He also argued that any benefit a Tier 1 FHC received in the market would be offset by higher compliance costs.