The Guest Blog

Isaac: Abolishing Too Big to Fail is Empty Rhetoric

William Isaac, Chairman Chairman, LECG Global Financial

Nearly all of our political leaders agree that we must banish the too big to fail doctrine in banking. We must never again, they chant, be held hostage by firms that are too big and too interconnected to fail.

While it is a catchy political slogan, their rhetoric is empty. Neither the financial reform bill approved last year in the House nor the bill promoted by Senate Banking Committee Chairman Christopher Dodd (D-Conn.) will eliminate too big to fail.

The five largest banks control some two-thirds of assets in the US banking system. As long as that condition exits, we will never be rid of too big to fail.

Large banks almost never get into major trouble in isolation – they are too diverse for that to happen. When the viability of a mega bank is threatened there is almost certainly something very wrong in the markets, and most if not all large banks are suffering.

The government cannot and will not allow the largest banks to fail because the economy would collapse. No law enacted by Congress will override that law of economics and political imperative.

Suppose Congress went so far as to declare that “the government may not under any circumstance provide any financial assistance to prevent any bank from failing,” which is a far stronger admonition than any language under consideration. When the next banking crisis hits – which will be all too soon if we do not make substantial reforms in the way we regulate banks – there will be a new Henry Paulson on the scene who will race to Capitol Hill to demand a taxpayer-funded rescue package.

In fact, the likelihood of a massive taxpayer bailout will be increased greatly if the authority of Federal Reserve and Federal Deposit Insurance Corporation to stabilize the system in an emergency is curtailed significantly, as the current legislative drafts propose.

The current reform proposals have it upside down. Instead of focusing so much energy on forcing mega banks to fail in an orderly way, which is not going to happen, the reforms should be directed at vastly improving the regulation of banks to keep them out of trouble.

Senator Dodd had it largely right last November when he proposed to consolidate oversight of federally chartered banks and thrifts and their holding companies into a strong, independent Financial Institutions Regulatory Authority. The Federal Reserve and Treasury could have two seats on the FIRA’s five-member board, giving them access to information and a voice in policy.

The FDIC should remain an independent watch dog for federally chartered institutions and could oversee state-chartered institutions. This would preserve the state/federal banking system.

While the Senate and House bills would create a Systemic Risk Council to monitor developing risks to the system, both bills would neuter the Council by putting it under the control of the Treasury, the Fed and the other agencies it is supposed to be overseeing. A strong, independent Council is critical to avoiding repetition of the policy blunders that led to the panic of 2008.

Those blunders include allowing the removal of trillions of dollars of assets from bank balance sheets thereby avoiding capital requirements; highly destructive mark to market accounting; pro-cyclical bank capital and loan loss reserve models; the explosive high-risk growth of Fannie Mae and Freddie Mac; pro-cyclical FDIC insurance premiums; reduced capital requirements for investment banks; and elimination of restrictions on short sellers.

What makes us think that the same regulatory regime that gave us the banking and S&L crises of the 1980s and the panic of 2008 is going to avoid the next crisis? What gives us confidence that the Treasury has the wisdom and political independence to lead the Systemic Risk Council in the right direction?

Treasury pronounced in the early 1980s that the S&L problem was not one of “solvency” but an “earnings” problem and that the correct remedial action was to grant S&Ls broader powers, use “regulatory accounting” to mask the industry’s insolvency, and allow S&Ls to grow more rapidly. These policies resulted in $150 billion of taxpayer losses.

In recent years, the Treasury (along with the Fed) advocated capital models (Basel II) to allow US banks to reduce their capital levels to international norms. We are very fortunate that an independent FDIC resisted this move every step of the way.

The House and Senate reform bills are terribly flawed, will do more harm than good, and should be rejected. It is critical that we get the right reforms in place this time, and these bills do not come close.

Mr. Isaac, Chairman of the FDIC during the banking crisis of the 1980's, is chairman of the LECG Global Financial Services, based in Washington DC and is a CNBC Contributor.