Tony Fratto: Resolving the Big Bank Problem

One of the most vexing problems that emerged from the financial crisis involves how the government deals with the pending failure of a large, systemically-important financial institution.

Since the failure of Lehman Bros. in September 2008, analysts have focused on whether federal authorities should or should not have saved the institution, and possibly staved off the global upheaval that followed.

Then-Treasury Secretary Hank Paulson, Federal Reserve Chairman Ben Bernanke, and then-New York Fed President (now Treasury Secretary) Tim Geithner all agree: regardless of the efficacy of saving Lehman, they simply lacked the legal tools to do so.


Seeking to add clarity and predictability should such an event occur in the future, Secretary Geithner wants the legal authority and financial means for the government to resolve a failure in an orderly way.

It's hard to argue with Geithner's motives -- any policy official dealing with the cataclysmic events of last fall, with the frustratingly primitive and limited tools at their disposal, would want greater powers. Geithner et al don't want to have to MacGyver another financial rescue with the policy equivalent of bubble gum and baling wire.

At the same time, giving the federal government take-over authority, while appealing, could have the potential to accelerate, if not create, the very conditions necessary for the failure of a big bank.

The problem most have focused on is the so-called "moral hazard" of takeover authority -- that banks will be reckless as long as they know that there's a federal backstop. I tend to discount this notion. I don't believe banks willingly take on self-destructive risk for the same reason that auto insurance doesn't cause me to be a dangerous driver.

Another problem cited is the "implied subsidy" to big banks -- that too-big-to-fail banks can access capital more cheaply because of an implied federal rescue. This is an important public policy question and it needs to be studied -- and, if real, mitigated. But I don't believe it's a condition that sews the seeds for failure of the financial system.

For me, the more difficult problem is more practical, and rooted in the very nature of an actual federal takeover. That is, as a necessary condition of a takeover, equity shareholders in the bank must be wiped out. I don't disagree with the principle of inflicting pain on equity shareholders. Equity investors should not be rewarded by taxpayers for making bad bets.

This is, in fact, what happened with the resolution of Bear Stearns, and later with Fannie Mae and Freddie Mac . Those who refer to Bear Stearns as a "bailout" should talk to shareholders and employees who had their assets obliterated.

But the principle complicates efforts to prevent a possible failure, even as it is necessary in dealing with an actual failure.

To understand this better, we need to go back before "Lehman Weekend" in mid-September 2008 -- a time when the bank was clearly weak and listing, but bankruptcy wasn't yet seen as likely.

The government at the time was counseling all large financial institutions -- Lehman, Fannie Mae and Freddie Mac, among others -- to raise private capital to sure up their balance sheets.

If government at that time had the authority to take over Lehman Bros. with the clear intention of wiping out shareholders should it step in, what investor in their right mind would have invested capital in Lehman Bros.? Investors would be more likely to run for the exits rather than risk the "pain" federal authorities would certainly impose.

In reality, it's possible that the example set by the treatment of Bear Stearns shareholders weighed on the minds of investors last year as Lehman sought their support.

Secretary Geithner is, of course, aware of the potential that federal takeover authority could have an accelerating effect on a weak institution. He believes the benefits of an orderly resolution are greater than the risk posed by the presence of resolution authority.

It's not an easy call, but as messy and politically tortuous as the financial rescue was, I believe it's better for government to focus on broad safety and soundness provisions -- as it is with new attention to capital standards, leverage, liquidity, and risk -- and to set aside remedies that distort the incentives for financial institutions and investors to help themselves.

It's possible that federal authorities could in the future decide to prevent the disorderly collapse of a large systemically-important financial institution. But such an act should be extraordinary -- and extraordinarily difficult. It should not be implicit, let alone a statutory likelihood.

Tony Fratto is a CNBC on-air contributor and most recently served as Deputy Assistant to the President and Deputy Press Secretary for the Bush Administration.