by Andrew Sprung

In a too-brief interview with Tim Fernholz, Elizabeth Warren, chair of the Congressional Oversight Panel for the bank bailouts, lays down an important regulatory principle and makes an important distinction. My italics:

Should the government step in and break up the biggest banks?

There are a lot of ways to regulate "too big to fail" financial institutions: break them up, regulate them more closely, tax them more aggressively, insure them, and so on. And I'm totally in favor of increased regulatory scrutiny of these banks. But those are all regulatory tools. Regulations, over time, fail. I want to see Congress focus more on a credible system for liquidating the banks that are considered too big to fail. The little guys aren't immortal; they pay for their mistakes. The big guys can't be immortal either. A free market cannot operate in a too-big-to-fail world.

In other words, it's more important to ensure that regulators can clean up failed banks, no matter how big, without systemic risk than it is to empower them to prevent large banks from failing. That's a conservative principle from the country's foremost financial consumer advocate.  Warren wants to create the conditions that Alan Greenspan believed the market would impose unaided -- in which the real possibility of failure itself "regulates" the thinking of bank executives.

Perhaps because of her governmental role, it's hard to find much detail on Warren's assessment of the bills currently pending. I would like to know what Warren thinks of the way the House and Senate bills handle resolution authority for the big banks -- and what ancillary legislation is most important in her view. How important is the $150 billion fund that the House bill collects from big banks to cover the possible failure of one of their own? What about the provision that allows for secured creditors losing up to 20% of their loan value in the event of a failure?  What about the proposed so-called "living wills" that would help receivers unwind the assets of big banks that fail?

Perhaps, too, the line is a bit blurry between Warren's "regulations," which "over time, fail" and a "system for liquidating the banks," which would in a sense run on autopilot since it would safeguard the possibility of failure. Take, for example, the  Kanjorski amendment that passed as part of the House banking bill last week, which enables regulators to take pre-emptive action to prevent banks from getting "too big to fail." 

The bill "considers a variety of objective standards to determine if financial firms pose a threat to our financial stability, including the scope, scale, exposure, leverage, interconnectedness of financial activities, as well as size of the financial company" (but does not limit the size of financial institutions, as Peter Boone and Simon Johnson have suggested such a bill might).  While that mainly falls under the heading of 'regulation,' it does include the authority to block mergers and acquisitions or force the breakup of a company if it's deemed a systemic risk.

The effectiveness of that provision depends on the human judgment of  the Financial Services Oversight Council that would exercise its powers. But to the extent that it's effective, it would help keep banks from getting too big to fail as well as presumably helping to keep them from failing.

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