US Is Still Facing Hurdles In Regulating Financial Giants

“I think what is missing is a comprehensive dissolution authority to address systemically critical firms,” Bernanke told the Senate Finance Committee recently under tough questioning. "The existing rules don’t cover a Citigroup because it is a bank holding company with many parts.”

Both Citibank and the holding company, Citigroup, are enormously large yet separate institutions with assets of more than a billion dollars. But unlike the bank, whose core business is deposits and lending, the holding company’s activities involve a diverse group of financial activities, from investment to insurance, most of which aren't regulated or insured by the government.

The world of finance and the structure of financial institutions have changed in recent decades, but while the government was undertaking sweeping deregulation it failed to make the necessary changes to provide proper supervision, says experts.

In addition, the management and balance sheets of the two institutions have become irrevocably intertwined.

“The Fed and bank regulators were not prepared to deal with big bank holding companies,” says economist George Kaufman, a banking expert at Loyola University who also does consulting work for the Federal Reserve Bank of Chicago. 

Experts say there were numerous opportunities to address the issue, particularly with the passage of the Gramm-Leach-Bliley legislation of 1999, which repealed part of the Depression-era Glass-Steagall Actof 1933 and allowed banks, insurers and investment firms to essentially compete with each other for consumer’s dollars.

Experts say AIG, because it is regulated by many individual state authoriities and also has a thrift, or lending, unit, regulated by the federal Office of Thrift Supervision, presents the same holding company quandry for officials.

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The situation has become further complicated because of the proliferation of exotic financial instruments, namely derivatives, and a high level of risky investments, many of which now fall into the toxic asset category.

“There's plenty of blame to go around but there's no question, the Fed has not done a very good job of regulating the holding companies," says Lawrence White, a former S&L regulator and White House economist, now with NYU's Stern School of Business.

Kaufman is among those who would like government officials “to have the authority to treat the holding company like they treat the bank—put them through a regulatory process, not a bankruptcy.”

“The problem is the liabilities," says Glauber. "What do you do with the uninsured liabilities? Are you going to protect senior debt, secured debt?”  

Such liabilities involve so-called counter parties, the people on the other end of the business transaction. Unlike bank depositors, their interests and rights can’t be settled simply, quickly or fairly.

The perils of that scenario became apparent after Lehman Brothers—unlike Bear Stearns—failed to attract a last-minute buyer or a government lifeline.

"The  Chapter 11 process is not amenable to quick resolution and improvisational solutions,” says Rob Johnson, a consultant and former chief economist for the Senate Banking Committee during the heyday of deregulation. “It’s a bit of tragedy that we didn’t think of this,”

Though no one is urging nationalization, some takeover authority, says White, has to be part of the “resolution solution”, as the government tries to cut its losses.

"What do you do with Bank of America ," says White. "It can't sell Merrill Lynch. There's no market out there."

In something of an ironic twist, the Treasury under Henry Paulson was moving toward addressing the outdated regulatory structure in early 2008 when the financial crisis kicked in. Its regulatory blueprint effort was essentially overtaken by events, including the then earth-shattering collapse of Bear.

That is, in part, why the Obama administration is moving ahead on financial reforms, though it's unclear whether that will include giving regulators more authority over holding companies.

"I get the feeling this is an issue that’s being discussed quietly,' said Corker, who added he plans to push Senate Finance Committee chairman Christopher Dodd (D-Conn.) and others to focus on the issue.

"We have to either temporarily or in a more thoughtful way on a permanent basis move to give the the Fed or some other entity the ability to unwind one of these things in an orderly fashion," says Corker.

As with other govenment initiatives in tackling the financial crisis, that may involve some tough choices.

“They simply don't want to face up to the question about what you protect and what you don't protect,” says Glauber.

© 2011 CNBC.com

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