Bank bailout made matters worse if no reform is enacted, Treasury aide says

Unless substantial regulatory reforms are now enacted, the government’s bailout of large financial institutions last year will have made the too-big-to-fail problem worse by creating a “classic moral hazard,” a top Treasury official said.

Going into the crisis, assistant Treasury secretary Michael Barr testified before a House Judiciary subcommittee, large, highly leveraged, and substantially interconnected financial firms benefited from the perception that the government could not afford to let them fail.  

Creditors and investors accepted that these firms could grow larger, take on more leverage, engage in riskier activity and avoid paying the consequences should those risks turn bad.

“It is a classic moral hazard problem,” Barr said in his written testimony. “We must end the perception that any firm is too big to fail.”

Barr conceded that the bailout in last year’s crisis was necessary. “But there is no question that unless we enact meaningful reforms, the fact that the federal government intervened this past year will have made the problem worse,” he said.  

The administration’s proposal for a resolution authority for large non-bank financial firms addresses this problem “head on,” Barr said.

However, he said that the resolution authority, similar to the FDIC’s current authority to seize banks and wind them down, is not intended to replace bankruptcy proceedings.

“Bankruptcy is and will remain the primary method of resolving a non-bank financial firm,” Barr said.  But the collapse of Lehman Brothers last year demonstrated that existing options under the bankruptcy laws are not adequate to deal with the insolvency of large financial institutions in times of severe crisis, he said. 

“The resolution authority…allows the government to impose losses on shareholders and creditors without exposing the system to a sudden, disorderly failure that puts everyone else at risk,” Barr said.

The administration’s proposal includes conditions that ensure it would be used infrequently, he said.  It would require the Treasury secretary and president to determine a financial company was at risk of default before action was taken. A decision to do so would only be made if the Federal Reserve and the appropriate federal regulator recommended it.