Geithner’s Solution for Too-Big-To-Fail

By Lisa Valentine

U.S. Treasury Secretary Tim Geithner called for five reforms to deal with the problem of U.S. financial firms that are “too big to fail,” creating a moral hazard where these firms benefit from knowing that the government will catch them if they fall.

The five reforms Geithner presented to the House Financial Services Committee are:

1.    Give the government the ability to resolve failing major financial institutions in an orderly manner that doesn’t rely on taxpayer bailouts. Instead, equity holders, unsecured creditors and possibly even financial institutions should bear the failure. The bankruptcy code doesn’t cut it—it’s too slow to implement and doesn’t take into account the ripple effect from the failure of a large, interconnected financial institution.

2.    Eliminate open bank assistance to failing financial institutions. The government could not put money into a failing firm unless the firm is in government receivership or being unwound, sold or liquidated.

3.    Protect taxpayers from losses. The government should be able to recoup any losses by charging a fee to large financial firms.

4.    Limit the Federal Reserve and Federal Deposit Insurance Corporation (FDIC) emergency authorities so they could step in and support a failing financial firm only to protect from systemic failure. This would mean appealing section 13(3) of the Federal Reserve Act which gives the Federal Reserve the ability to extend credit to failing non-bank firms. (Geithner said that the Fed should be able to use 13(3) during “periods of severe stress in the financial markets or U.S. economy” as long as they get permission from the Treasury and two-thirds of the members of the boards of the Federal Reserve and the FDIC.)

5.    In addition to imposing stricter capital and liquidity requirements, regulators should be able to force major financial firms to reduce their size or restrict the scope of their activities.

Number 5 is the kicker. Who are these major firms, and what constitutes a firm that is too large or is involved in too many businesses? Geithner said that the government will not prepare a blacklist of these firms, but it’s easy enough to figure out what firms he’s referring to.

Limiting the size of financial firms was mentioned almost toward the end of Geithner’s prepared testimony, which is interesting since solving the problem of moral hazard by not letting firms get too big to fail in the first place is not something that the Obama administration has focused on before.

It would be good to know who is responsible for cutting government down to size when it gets too big and gets its tentacles into all sorts of business it doesn’t belong it.