Use Bankruptcy Courts...

Use Bankruptcy Courts Not More Financial Regulation

James Gattuso

Bigger government and pre-funded bailouts won't fix the system. Instead, the focus should be on establishing an effective bankruptcy system for large financial firms, to allow failures to be addressed in the same way failure is addressed in other industries.

"I'm from the government, and I'm here to help."

Ronald Reagan considered those nine words the most terrifying in the English language. And the government has been offering a lot of such help lately. Most recently, of course, is the trillion-dollar health care bill — chock-full of expensive mandates, prohibitions and regulations.

But, barely coming up for air, Congress and the Obama administration are at it again: this time targeting the financial system. Only one day after Congress approved the health care bill, the Senate Banking Committee approved a massive regulation bill for the financial world.

The plan, sponsored by Sen. Christopher Dodd, D-Conn., is aimed at fixing the financial system. Supporters argue the plan would end "too big to fail" (the notion that some firms are too important to be allowed to go under) and prevent future taxpayer bailouts of financial institutions. Those are fine goals, but there's one problem: The plan would do nothing to achieve them. In fact, it would extend "too big to fail," while in effect creating a permanent bailout program.

First, the bill would create a new Consumer Financial Protection Bureau, to be located within the Federal Reserve Board bureaucracy. While not technically independent, the new agency would be largely autonomous. But not only are there plenty of laws on the books already against consumer fraud and deception, such activity had little or nothing to do with the recent financial crisis. Moreover, autonomous consumer regulators would almost certainly work at cross-purposes with other regulators charged with ensuring the safety and soundness of institutions.

Next, the bill would establish a powerful Financial Stability Oversight Council. It would be made up of nine existing agencies, with broad regulatory power over firms considered "systemically important," including authority to order the firm to break itself up, stop selling certain products or even go out of business.

The idea is to stop firms from presenting a danger to the system as a whole. But no one really knows how to identify systemic risks in advance. In fact, none of the nine existing regulators foresaw the present crisis, so it's hard to see how this new council will prevent the next one.

Moreover, by singling out firms whose failure would present a danger to the financial system, regulators would in effect be telling investors that the government would not allow them to go under. In effect, these firms would enjoy an implicit federal guarantee, protected from the full consequences of risk-taking. "Too big to fail" would be institutionalized, not ended.

It gets worse. Treasury and other regulators would have the power to seize and liquidate financial firms that they feel are in trouble, even if investors and board members didn't agree. Of course, the decision to impose such "resolution authority" would, under the Senate's plan, have to be confirmed by a panel of bankruptcy judges. But look closely. The standard of review would require the judges to uphold the seizure if the regulators have any "substantial evidence" to support their action. The deck is stacked in favor of government seizure.

At the same time, the Senate bill would create a $50 billion fund to be used to help finance these forced liquidations, to soften the blow for some creditors. Supporters say this funding would be used in only the rarest of cases. Nonsense. If governments have access to money, they tend to use it. This is nothing more than a permanent TARP (Troubled Asset Relief Program) fund.

This is the wrong approach to fixing our financial markets. Bigger government and pre-funded bailouts won't fix the system. Instead, the focus should be on establishing an effective bankruptcy system for large financial firms, to allow failures to be addressed in the same way failure is addressed in other industries.

For most industries, the bankruptcy laws have long provided a way for failing firms to reorganize or liquidate, under established rules of law and with independent non-political supervision by courts. There is no reason, with perhaps a few modifications to take into account the special characteristics of large financial firms, it can't work here, as well.

Despite its flaws, Dodd's 1,300-page bill cleared a Senate committee in 22 minutes. At that pace, it's difficult to argue that lawmakers are giving these important matters due consideration.

They need to take a breath — and reconsider their approach.