‘Too big to fail’ becomes ‘too much to stomach’

The Obama administration’s new proposal for tackling financial risk in the U.S. economy, unveiled just two days ago, came under attack on Thursday from Congress and regulators, with questions raised about its funding and scope.

U.S. Treasury Secretary Timothy Geithner scrambled in a congressional hearing to defend the plan against critics who said it would give too much power to regulators and enshrine government bailouts for troubled financial firms in law.

Released by the Treasury Department and Democratic Representative Barney Frank on Tuesday, the plan is an bold attempt to make sure the Bush administration’s confused handling of last year’s financial crisis doesn’t happen again.

That episode saw some firms, such as AIG and Citigroup, get multibillion-dollar bailouts. Others, such as Lehman Brothers, were allowed to go into bankruptcy, while still others were forced into government-engineered mergers.

The 253-page Obama plan tries to strike a balance between bailouts and bankruptcy, while insisting that large financial firms, not taxpayers, foot the bill for future interventions.

“Without the ability for the government to step in and manage the failure of a large firm and contain the risk of the fire spreading, we will be consigned to repeat the experience of last fall. It’s a really stark, simple thing,” Geithner said at a hearing of the House of Representatives Financial Services Committee, chaired by Frank and packed with bank lobbyists.

Amid concerns that a few elite financial giants have become “too big to fail,” the administration’s plan would empower regulators to police, restructure, and even shut down large firms that threaten stability. It resembles the Federal Deposit Insurance Corp’s power to seize and dismantle troubled banks.

Bankruptcy would be remain the dominant tool for handling non-bank financial firm failures, Geithner said.

“But as the collapse of Lehman Brothers showed, the bankruptcy code is not an effective tool for resolving the failure of a global financial services firm in times of severe economic stress,” he said.

The plan is meant to mesh with many other financial regulatory reform proposals being pursued by the administration and congressional Democrats.

Ranging from regulation of over-the-counter derivatives and setting up a financial consumer watchdog agency, to curbing bankers’ pay and cracking down on credit rating agencies and hedge funds, the reform push has been making halting progress.

Final action is still months away. Frank’s committee has approved some proposals, but votes by the full House await and the Senate has barely begun handling the matter.

“Congress will be split” over the new systemic risk plan, said financial services policy analyst Brian Gardner at investment firm Keefe Bruyette & Woods.

“Opposition cuts across party lines. We also expect significant opposition to increasing the Fed’s role as a banking regulator in the Senate and we think this bill’s prospects are far from certain,” Gardner said.

“This means a long fight over this bill which could last well into next year if not beyond, in our view. We think there is consensus in Washington on the need to deal with systemic risk. There’s just not a lot of consensus on how to do it.”

In the hearing, Republican Representative Jeb Hensarling said the plan would “institutionalize ‘too big to fail’.”

Democratic Representative Brad Sherman said it would give the administration too much power over spending and taxes. He called the proposal to “TARP on steroids,” referring to the $700-billion Troubled Asset Relief Plan launched in the final, hectic days of the Bush administration.

The Obama plan lacks oversight and limits on government aid, he said, and could sanction “the greatest transfer of money from the Treasury to Wall Street in U.S. history.”

Funding was a key point of debate in the hearing, as well.

As drafted, funding would not come from an established pool of money like the FDIC’s bank insurance fund. Instead, firms with more than $10 billion in assets would be charged on a case-by-case basis to reimburse the Treasury for loans extended to the FDIC to finance interventions in failing institutions.

Questioning this arrangement, FDIC Chairman Sheila Bair argued firms should be made to kick into a fund in advance.

Republican Representative Judy Biggert said the administration’s funding proposal “could create perverse incentives” since survivors would have to foot the bill for firms that fail in financial crises.

Democratic Representative Luis Gutierrez said a pre-funded mechanism like the FDIC’s fund makes sense and would not likely encourage financial firms to take on excessive risks.

But Geithner replied that a standing fund “would create expectations that the government would step in to protect shareholders and creditors from losses … In essence, a standing fund would be viewed as a form of insurance.”