Banks aren’t safe counterparties yet, and taxpayers aren’t free from the threat of having to fund another big-bank bailout, according to government officials and members of Congress.

New legislation addressing banking’s “too-big-to-fail” (TBTF) problem was introduced on the floor of the U.S. Senate Wednesday, a day after the inspector general of the Troubled Asset Relief Program (TARP) issued a report highly critical of regulatory attempts to eliminate the implied U.S. government backing of large banks.

The Senate bill, called the Terminating Bailouts for Taxpayer Fairness Act, proposes strict standards for bank capitalization and other measures to avoid another breakdown of the banking system and to limit the necessity for injections of capital into banks by the federal government.

But before the bill came out, Christy Romero, the TARP inspector general, said banking regulators need to do much more to end TBTF. She said U.S. regulators had yet to sever the “dangerous” interconnectedness of financial institutions or establish confidence that they can avoid another taxpayer bailout and “close down a bank without damaging the economy.” According to Romero, “As a nation we are not there yet.” 

In the inspector general’s quarterly report to Congress, Romero analyzed the existing measures in the Dodd-Frank Wall Street Reform and Consumer Protection Act that address the problem: in the first case, the “front line” efforts to keep banks safe and sound. Those proposed measures include capital surcharges on the megabanks.

But those surcharges have yet to be determined, she pointed out. The Senate bill, if passed, would make the capital requirements for U.S. banks tighter than global standards. It would require all banks to hold capital equal to 10 percent of their assets (200 basis points higher than Basel III standards) and megabanks as much as 15 percent of their assets.

Romero sees stricter capital requirements as a way to counter the funding advantage TBTF banks have and to force big, complex financial institutions to break themselves up. “Ending too big to fail will require hard choices by companies to break up certain products or business lines and break off dangerous interconnections,” according to Romero.

Romero was also skeptical of the other Dodd-Frank solution to too-big-to-fail: what she calls “last line” defenses “aimed at letting a company fail without damaging the economy.”

Dodd-Frank tries to do this through “living wills,” guides to dismantling the complex operations of some banks. The wills, which are still being written by the banks,  are supposed to disclose off-balance sheet exposures, identify to whom the bank pledged collateral and detail material hedges and hedging strategies.

Knowing those things would allow regulators to let a big bank fail but limit the contagion. It would also let the Federal Deposit Insurance Corp. more easily exercise its new “orderly liquidation authority.” The authority gives the FDIC the power to put a parent company in receivership, fire management and keep a bank’s subsidiaries functioning.

But Romero said that when a bank is failing, living wills may be of limited use. “There may be no time for bankruptcy,” she said, pointing to the collapse in short-term funding that led to the swift fall of Lehman Brothers and others five years ago.

More importantly, Romero noted, the existence of living wills and the liquidation authority “have not [yet] convinced the market to change its perception that select financial firms will get another bailout, and have not convinced megafirms to simplify their organizations or disentangle dangerous interconnections.

In addition to requiring banks build safer capital structures, the new Senate bill, introduced by Senators Sherrod Brown (D-Ohio) and David Vitter (R-Louisiana), would require banks to hold more equity and prevent the Federal Reserve from extending any life support to non-depository banks during a crisis. Political analysts say many lawmakers – and bank lobbyists – will fight the legislation.

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