First step: Prevent crisis
Barney Frank is a busy guy.
Frank is the chairman of the US House Financial Services Committee, which has been furiously pumping out legislative bills dealing with America’s financial system and the crisis it brought upon itself. The Massachusetts Democrat has won his share of fights and lost a few along the way.
His committee recently took small steps in the right direction by advancing bills that would impose some regulation on financial derivatives, tighten restrictions on credit rating agencies, require the registration of hedge funds, and create a financial consumer protection agency. Some measures, such as the one regulating derivatives, are far from perfect but at least a start.
Frank and the committee took up one of the biggest issues of the financial crisis yesterday, hearing testimony on legislation to change the way government handles institutions deemed too big to fail. That bill, drafted jointly by Frank and the Treasury department, is supposed to make it easier for government to act quickly when a faltering giant threatens the economy. It also tries to push the expense of a clean-up off on all the other institutions that are too big to fail.
Banks and other financial companies deemed too big to fail are too important to ignore. But much of the Frank/Treasury bill approaches the issue backwards. It emphasizes what government powers and actions would be triggered if one among the too-big-to-fail institutions did run off the rails. The price to be paid by the others would be charged at that time, at least theoretically avoiding the necessity of a public bailout.
Legislation and regulation should be focused on ways to make sure a disaster doesn’t happen in the first place. Money that would help sop up the damage of any failure that does take place should be collected far in advance.
Banks and other financial institutions have been consolidating for more than two decades on the working premise that bigger is better. America was said to have too many banks, making the system inefficient and pushing the cost of money artificially higher for borrowers. No one thought too much about the risks consolidation created.
Now we do. The best way to avoid disaster is to restrict risk-taking at places that can’t be allowed to fail. That means greater capital requirements, better ongoing regulation of individual institutions, and limits on riskier activities. The bigger you get, the higher the bar should be raised.
Limits like that may be a real problem for giant banks and their stocks could suffer. The value of a company’s parts may not be reflected in the total market price of a conglomerate’s shares. This happens all the time in other industries, and markets come up with their own solutions. They break off pieces, or break up the company entirely, to improve the value of the business.
Would anyone shed a tear if Citigroup was broken into pieces and no longer posed such a serious risk to the economy?
Jump ahead to the issue of who pays in the case of a disaster. The idea that other banks classified as too big to fail write checks and solve the problem on the spot is crazy. The scale of a failure could easily eclipse their ability to pay.
A problem at one giant would likely weaken the others. Demands for payment at that moment could create a catastrophic domino effect.
One solution: Make them pay on a regular basis when no crisis exists. Companies deemed too big to fail will enjoy serious advantages in the marketplace. That backstop designation would guarantee those banks could raise capital and borrow money on better terms than everyone else.
They would always get the too-big-to-fail discount. That’s precisely how Fannie Mae and Freddie Mac exploited their implicit government guarantee for years.
“Why not identify who they are and take away the discount,’’ says Con Hurley, director of the Morin Center for Banking and Financial Law at Boston University. “That discount exists as a result of the taxpayers’ subsidy. It doesn’t belong to the banks, it belongs to the taxpayer.’’
The too-big-to-fail question is no wonky sideshow. It’s one of the issues at the heart of the near calamity in our financial markets. Legislation should emphasize ways to avoid a new mess in the future, not how to clean it up.
Steven Syre is a Globe columnist. He can be reached at syre@globe.com. 
