Will Financial Reform End Big Bank Bailouts?

Article excerpt

Lawmakers are pledging to end bailouts in the financial reform bill that the Senate is considering now. But many experts say bank bailouts can and will occur again.

"Orderly liquidation." The words appear prominently in financial reform bills to overhaul the way the US government will regulate America's financial system in the aftermath of a near-meltdown in late 2008.

The idea is that if a large firm gets into trouble in the future, it can't expect any generous taxpayer bailouts, as happened at American International Group (AIG) and other firms. Rather, if a large bank takes big risks that go awry, regulators will preside over its dismemberment with steely resolve.

That, at least, is the simple message lawmakers say they want to send with legislation that's moving into its second week of Senate floor debate.

President Obama, too, has been pledging an end to bailouts. "That's what this reform does," he said recently of the Senate bill.

But regulating the vast financial system is anything but simple, and many experts say bank bailouts can and will occur again, even if Mr. Obama ends up signing a reform bill by midyear.

A basic problem lies in that phrase, "orderly liquidation." In the heat of a financial crisis, that's something very hard to do with a large and interconnected financial firm on the brink of failure.

Orderly liquidation is exactly what did not occur in 2008. During the crisis, most tottering firms - from sprawling Citigroup to insurance giant AIG - received some form of government backing. Then, when Lehman Brothers didn't get a government bailout, credit markets quickly spiraled down toward what could have become a broad and catastrophic collapse. To restore stability, Congress held its nose and created a $700 billion rescue fund.

For regulators and Congress, propping up the economy trumped a distaste for bailouts.

"In a crisis, they'll do the same thing again," predicts Peter Nigro, a finance expert at Bryant University in Smithfield, R.I.

No outright ban on bailouts

The bills in the House (already passed) and Senate (in progress) include tough language designed to make bailouts both less common and less generous in the future.

But some critics of the legislation say it will fail to end bailouts, and that this is a bad thing. The real problem during 2008, they say, was not that Lehman wasn't rescued but that investors had come to expect government aid rather than insisting upon caution and discipline in financial activities. The proposed bills will perpetuate this problem, these critics warn.

At the other end of the spectrum, some economists say the opposite: The law may succeed at preventing bailouts - and that this is a bad thing. You don't want to tie regulators' hands in a crisis or possibly make a crisis worse by moving to dismantle large firms.

A middle view is that the legislation strikes a reasonable balance. These financial experts say the bill puts investors in failing firms on notice that they will bear losses when a firm gets in trouble, while also giving regulators the flexibility to contain any economic ripple effects from a firm's failure.

"A lot of the discussion has been overly simplistic," says Dean Baker of the liberal Center for Economic Policy and Research in Washington. For all the talk about the need to end bailouts, he says, the bills still give "relatively open-ended authority" to government officials in a crisis. "I'm not upset that they have that option," he says.

In the 2008 crisis, the recession might have become much worse without the safety net provided by that $700 billion Troubled Asset Relief Program and extraordinary Federal Reserve lending activities, for example.

In this light, the question of "bailouts" versus "liquidation" is not just one of fairness to taxpayers. The larger question - the issue that's -fueling the drive for financial reform - is how to protect the economy from financial crises. …

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