The U.S. Congress probably has broad authority to empower regulators to take over big banks and other giant financial companies, even if shareholders and other creditors lose out, analysts said.
The Obama administration is expected to propose on Wednesday the biggest regulatory overhaul of the industry since the 1930s, including giving the Federal Reserve power to oversee systemic risk in the economy in conjunction with an inter-agency council of regulators.
In extreme circumstances, such power could include seizing control of a bank or insurer whose failure could threaten the financial system. That could further upset investors already enraged by the government's directives to the auto industry.
But analysts said Congress' legislative power would make it tough for financial companies' creditors upset over how their interests are treated to raise constitutional challenges.
The answer is probably no, said Adam Pritchard, a law professor at the University of Michigan. Legislators may make it clear that the systemic risk regulator's authority trumps other agencies. It is possible to avoid constitutional issues by allowing the president to select the head of the uber-risk regulator, subject to Senate approval.
Reforms to the regulatory scheme are designed to repair the current patchwork of oversight and limit risk that companies can take. One goal is to reduce the chance that any one firm becomes so overextended that failure to intervene threatens financial and credit markets.
In the last 16 months, the government has provided broad support to several companies considered too important to fail, including Bear Stearns Cos, Fannie Mae, Freddie Mac, American International Group Inc, Citigroup Inc and Bank of America Corp.
At the same time, the government's refusal to support another bank arguably fitting that definition, Lehman Brothers Holdings Inc, was a key trigger of a credit crisis from which the world is emerging only fitfully.
Goldman Sachs Group Inc, JPMorgan Chase & Co, Morgan Stanley and Wells Fargo & Co are other companies often considered systemically important.
Systemic risk was very much built into our financial system, Daniel Tarullo, who sits on the Fed board of governors, said on Monday. As we learned during the course of the crisis, the universe of institutions whose potential failure was regarded as having systemic consequences extended well beyond banks.
Recognizing the interconnected nature of the financial system argues in favor of a broad grant of regulatory power, according to Douglas Elliott, a fellow at the Brookings Institution in Washington, D.C.
There is a strong public interest in maintaining the health of banks and to the extent there is extra value, it does go back to the shareholders at the end, he said. It doesn't seem to be an illegal or arbitrary taking of property.
Aggrieved investors may disagree.
For example, Washington Mutual Inc creditors have accused the Federal Deposit Insurance Corp in a lawsuit of improperly letting JPMorgan Chase & Co buy the thrift's assets at a fire-sale price.
But this case may turn on how the FDIC exercised its authority to arrange asset sales, rather than having that authority in the first place.
IMPROVING THE SYSTEM
There is growing sentiment for letting big companies fail.
Tim Johnson, a South Dakota Democrat who sits on the Senate Banking Committee, said on Tuesday in the American Banker that, we would be much better advised if we simply dismantled gigantic, troubled firms instead of bailing them out.
He said this could involve a systemic risk council creating a good bank/bad bank model, where regulators try to sell troubled assets much as the FDIC does now, while shareholders and creditors bear losses, as they should.
Congress, moreover, has broad authority to regulate interstate commerce, said Lawrence Kaplan, a counsel at Paul, Hastings, Janofsky & Walker LLP in Washington, D.C. and former Office of Thrift Supervision lawyer.
There is no legal impediment for Congress to take power from one agency and give it to another, or to create a new regulator, Kaplan said. If a regulator took this authority without Congressional approval, that could be actionable.
A lesser approach would be to create conservatorships, similar to what the government did with mortgage companies Fannie Mae and Freddie Mac last September.
Creating a conservatorship arguably interferes with the rights of other creditors and shareholders, but I don't see much traction in that argument, Michigan law professor Pritchard said. Seventy years ago, the New Deal Supreme Court basically told Congress it can do what it wants in this area.
(Reporting by Jonathan Stempel; Editing by Andre Grenon)