A panel of experts called for the creation of a systemic risk regulator Wednesday, as lawmakers examined the too big to fail problem. Minneapolis Federal Reserve Bank President Gary Stern and Federal Deposit Insurance Corporation Chairwoman Sheila Bair told the Senate Banking Committee that the key to addressing TBTF is to reduce substantially the negative spillover effects stemming from the failure of a systemically important financial institution.

At its heart, the problem of TBTF is companies that believe there is an implicit guarantee from the government that they will be bailed out should they face a severe crisis. Examples include American International Group, Inc. which was saved and Lehman Brothers, which was allowed to fail with catastrophic consequences.

Stern has noted that the bottom line is that the current financial crisis was caused in part because creditors of complex financial institutions expected protection in the face of bankruptcy.

With that expectation large institutions took on excessive amounts leading to a highly leveraged economy on the brink of collapse.

Put another way, if policymakers do not address TBTF, the United States likely will endure an inefficient financial system, slower economic growth, and lower living standards than otherwise would be the case, Stern warned in prepared remarks.

Bair offered a fairly detailed plan to address the problem, recommending that Congress establish a systemic-risk council with representatives from the FDIC, Federal Reserve, Treasury Dept., and Securities and Exchange Commission each playing a role.

Centralizing the responsibility for supervising institutions that are deemed to be systemically important would bring clarity and focus to the efforts needed to identify and mitigate the buildup of risk, Bair said.

While Bair outlined a specific plan, Stern offered the issues that the council and lawmakers must address behind the TBTF problem.

He offered his recommendations for addressing TBTF, starting with seeking answers as to why policymakers to provide protection to uninsured creditors. Failure to address why the protection is provided will not credibly put creditors of systemically important firms at risk of loss, he explained.

Therefore, Stern said that the focus of addressing the TBTF problem should be on reducing the perceived and real fallout from spillovers. With a less catastrophic consequence, financial institutions will not be able to rely on government protection.

The specific reforms, known as systemic focused supervision, include increased supervisory focus on preparation for the potential failure of a large financial institution, enhanced prompt corrective action, and better communication of efforts to put creditors of systemically important firms at risk of loss, Stern said.

Finally, Stern urged lawmakers to avoid reforms that do not physically reduce spillovers. Specifically, he rejected the notion that simply strengthening traditional supervision and regulation of large firms will address the TBTF problem.

All those issues would be addressed in the resolution structure Bair proposed, which includes allowing the FDIC to deal with failed bank and thrift holding companies with the same power it now has over failed lenders.

By giving the FDIC authority to resolve a failing or failed bank's holding company, Congress would provide the FDIC with a vital tool to deal with the increasingly complicated and highly symbiotic business structures in which banks operate, Bair said.

As FDIC Chair, Bair is acquainted with the existing procedure for systemically important commercial banks that near bankruptcy. When a large commercial bank is in trouble, the FDIC steps in to operate a bridge bank, limiting financial disruptions.

The resolution mechanism for financial firms would explicitly address the tradeoff between reducing financial disruptions and minimizing the costs to taxpayers.

In his remarks, Stern expressed his support for such a regime, noting that he is in favor of the creation of a new resolution regime for systemically important nonbank financial institutions.

Maintaining the status quo with regard to TBTF could well impose large costs on the U.S. economy, the Fed President warned. We cannot afford such costs. I encourage you to focus on proposals that address the underlying reason for protection of creditors of TBTF financial institutions, which is concern for financial spillovers.

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