Explicit and implicit subsidies for "too big to fail" financial conglomerates are a leading cause of the current financial mess. Regulators first announced the TBTF doctrine when they defended the bailout of Continental Illinois in 1984. Over the past quarter century, regulators have repeatedly invoked the doctrine to justify government-financed rescues of major financial institutions.

As a result, the financial markets apply far less discipline to the largest institutions, which pay much lower rates on their deposits and bonds compared with smaller banks. Yet the biggest banks paid nothing for the TBTF subsidies they enjoyed from 1984 through 2007.

The current financial crisis has underscored the advantages enjoyed by TBTF conglomerates. Between October 2008 and the end of 2009, the 19 largest bank holding companies and AIG received $290 billion of capital infusions from the federal government. The same institutions issued $235 billion of bonds guaranteed by the Federal Deposit Insurance Corp. Those capital infusions and bond guarantees were provided on very favorable terms and represented a large transfer of wealth from the federal government to TBTF institutions.

Thus, the present crisis has removed any doubt that TBTF subsidies distort economic incentives and encourage excessive risk-taking by large financial conglomerates. We must shrink these subsidies and force megabanks to internalize the risks and costs of their activities. Unfortunately, the Senate regulatory reform bill eliminates one of the most promising reforms that could help us to accomplish those goals.

The House bill would authorize the FDIC to establish a systemic resolution fund with assets of $150 billion. The FDIC would create that fund by imposing periodic assessments on financial companies with assets of more than $50 billion. The Senate committee bill authorized a similar fund, but that provision was struck during Senate debates after furious lobbying by the largest banks.

A prefunded systemic resolution fund is essential for several reasons:

During a crisis megabanks would not have adequate resources to pay large assessments to cover the costs of resolving failures of their peers. History has shown that megabanks are typically exposed to highly correlated losses during a financial crisis because they pursued similar high-risk strategies during the boom that led to the crisis. Consequently, even surviving megabanks usually suffer heavy losses during a serious disruption, and a postfunded system would not be able to collect enough assessments in the short term to cover the costs of resolving failed financial giants. The FDIC would therefore need to borrow large sums from the government to cover its short-term resolution costs. Even if surviving megabanks ultimately repaid those funds over several years, the public and the financial markets would rightly conclude that the federal government had extended generous bridge loans to protect creditors of failed megabanks.

In a postfunded system, the most aggressive megabanks would effectively shift the costs of their risk-taking to their more prudent peers. The most reckless institutions would probably fail, and their creditors would receive protection even though the failed institutions paid nothing into the systemic resolution fund.

A prefunded systemic resolution fund could create beneficial incentives for prudent behavior by imposing risk-based premiums on systemically important institutions. Moreover, each megabank would have good reason to monitor the behavior of its peers and to alert regulators to excessive risk-taking by those institutions. Each megabank would know it stood to lose its investment in the fund and would be forced to pay additional risk-based premiums, if any of its peers failed in the future.

A prefunded systemic resolution fund with risk-based premiums would force megabanks to internalize more of the potential risks and costs of their activities. Finally, a prefunded system with sufficient resources would protect the federal government and taxpayers from having to underwrite future resolutions of failed financial giants. At the very least, the first losses from future resolutions would be borne by megabanks, not by taxpayers.

To further reduce the potential TBTF subsidy for megabanks, the systemic-risk resolution fund should be strictly separated from the existing Deposit Insurance Fund. Congress should repeal the existing systemic-risk exception that allows the DIF to be used to finance bailouts of TBTF banks. In addition, Congress should designate the systemic resolution fund as the exclusive source of funding for all future resolutions of failed megabanks. Repeal of the systemic-risk exception would ensure that the DIF be used solely to protect depositors and not as a backdoor protection device for uninsured creditors of megabanks.

No one thinks a postfunded DIF would be adequate to protect depositors. Indeed, we have once again been reminded of the grave shortcomings of an underfunded deposit insurance scheme. Given the clear superiority of a prefunded DIF, we must ensure that Congress establish a prefunded systemic resolution fund to shrink the TBTF subsidies now exploited by large financial conglomerates.

It is hardly surprising that big banks made the House bill's prefunded systemic resolution fund their top priority for removal from the Senate bill. Megabanks have never paid for the costs of TBTF bailouts, and they don't want to start now.

If Congress lets financial giants keep shifting the costs of TBTF rescue to taxpayers, it will be a shameful dereliction of duty.

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