We would prefer that the government convincingly precommit to a policy of not saving financial institutions that fail. However, given everything that has transpired in the past couple of years, such a policy announcement would be greeted by laughter. No one would believe it.

As a result, the key issue for policymakers is not whether some banks are too big to fail, but who bears the cost of this status. The best solution is to change the way banks are regulated so the burden of getting too big to fail is carried by the same stakeholders who allow the company to get that way in the first place. Some regulator, perhaps the Federal Reserve � which tends to be relatively more isolated from political pressure � should have the discretion to certify if a financial company gets too big to fail or �TBTF.�

If the Fed designates a company as TBTF then some pre-set extra regulations should be triggered to make sure the bank does not take excessive risk at taxpayer expense.

Brian Wesbury and Robert Stein yesterday in their weekly outlook. This addresses the who decides question, but who is TBTF and what is the consequence? I think this is the important part of their proposal:

However, it is important to remember that every company should have a free choice about whether it wants to be in this position. Regulators would need to work with the banks to communicate when they are getting close to TBTF status, so banks know whether they are going to trigger this extra layer of regulation.

One key problem with President Obama�s drive to tax bank liabilities is that it would apply to many companies that are not particularly large, signaling investors that maybe some midsized companies are now TBTF. In other words, it casts the net way too wide. Another problem is that it�s based on a desire to raise revenue lost because of past policy mistakes, when it should be focused on preventing future policy mistakes.

It is interesting that the LA Times also editorialized on this point on Sunday.

How many initiatives can President Obama justify by pointing to the public's outrage over excessive bank bonuses? Last week the administration called on Congress to tax big banks, insurance companies and brokers to recoup what taxpayers spent bailing out the financial markets. This week the administration added two more items to its legislative to-do list: a cap on the size of banks, and a ban on certain types of investing. Although an argument can be made for the proposals, they go further than necessary to protect taxpayers against the risk of future bailouts. And that's the real goal, even if it's less politically satisfying than hammering banks.

But this administration's economic policy has never seemed to do anything that wasn't politically satisfying. At least when Bush wanted to do something satisfying he chose something hard like Social Security reform. Say what you will about the proposal, but populism was not in it. One has to wonder where this president would be if he didn't have "fat-cat bankers" to bash?

For a different take see Tom Cooley (h/t: Mankiw)

Labels: banking, economics