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Treasury rejects notion of too big to fail

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There will be no more bailouts of financial institutions, a top official of the Obama administration said Thursday night in what appears to be an attempt to pre-empt Republicans efforts to water down the Dodd-Frank Act.

“No financial institution, regardless of its size, will be bailed out by taxpayers again,” Mary J. Miller, U.S. Treasury undersecretary for domestic finance, said at a financial conference in New York.

Miller’s unequivocal comments appeared aimed at removing one of the hammers being wielded by Republicans against the Obama administration.

Specifically, it appeared to respond to comments April 12 by Rep. Jeb Hensarling, R-Texas, chairman of the House Financial Services Committee, that too big to fail must be ended. He said in remarks at the Center for Capital Markets Competitiveness that the Dodd-Frank Act (DFA) codified too big to fail with two provisions.

He said the first is Title II, providing for an orderly liquidation authority; and the second is allowing FSOC to designate financial firms as systemically important financial institutions. FSOC is the Financial Stability Oversight Council at Treasury. 

Becoming a systemically important financial institution (SIFI) is a double-edged sword, he said, since, while the firm is subjected to enhanced regulation, the designation implies a federal bailout.

Hensarling said that the FSC will take up legislation to repeal Title II and repeal the provisions authorizing FSOC to designate SIFIs.

Hensarling’s comments are consistent with the concerns of many insurers, who fear that SIFI is the camel’s nose under the tent for federal regulation, and such a designation would provide a competitive advantage for insurers so designated.

But Miller, without mentioning Hensarling by name, appeared to categorically reject his theories.

“Shareholders of failed companies will be wiped out; creditors will absorb losses; culpable management will not be retained and may have their compensation clawed back; and any remaining costs associated with liquidating the company must be recovered from disposition of the company’s assets and, if necessary, from assessments on the financial sector, not taxpayers,” Miller said.

She also said that the facts appeared to contradict the argument that being designated a SIFI gave large financial firms an advantage over their smaller counterparts.

“Following enactment of DFA, the rating agencies indicated that they would monitor the impact of financial reform implementation on the largest financial companies and adjust their ratings as appropriate,” Miller said.

Since then, she said, the rating agencies have removed as much as six notches of uplift attributable to expectations of government support.

One rating agency has also recently indicated it may further reduce or eliminate its remaining ratings uplift assumptions by the end of 2013,” Miller said.

“So, to the extent the largest financial companies have been benefiting from a funding advantage based on their ratings, that uplift has been declining and appears to be continuing to go away as implementation of DFA progresses,” Miller said.

She also said that other evidence also points to “potential market recognition of progress on financial regulatory reform implementation.”

Miller said that, “If investors still perceived large bank holding companies as too big to fail, we would expect to see low credit default swap spreads with little variation between the largest companies.

“However, compared to their pre-crisis baseline, the credit default swap spreads for the largest bank holding companies have not only increased on an absolute basis but investors have also increasingly distinguished between the largest bank holding companies as measured by the variance in their spreads,” she said.

Miller also said that “another interesting wrinkle” to this issue is that credit default swap spreads for these companies have recently been declining.

Miller said that her comments demonstrate “above all else that the evidence on both sides of the argument is mixed and complicated, making it hard to attribute the existence or absence of a funding cost advantage to any single factor, including a market perception of a too big to fail subsidy.”

The bottom line, Miller said, “is simply that it is important to acknowledge the difficulty of making these assessments and to be cautious about drawing conclusions in either direction.

“We will continue to carefully consider the developments and the work in this area, remaining mindful that our financial system is dynamic and that we need to remain vigilant to evolving risks,” she said.

Miller said Treasury and other regulators “must continue to work hard to reduce the risks posed by large financial companies and keep putting in place the measures to wind such companies down with minimal impact on the rest of the economy if the need arises.”

She said that to the extent the largest bank holding companies enjoy any funding cost advantage based on a perceived too big to fail status, ”these efforts should help wring it the rest of the way out of the market. 

“And most importantly, this work is making our financial system safer and a stronger, more reliable engine for providing credit to help our economy grow,” Miller said.

“This is a more accurate analysis than what we usually see, but it still doesn’t quite get to the issue of what makes someone too big to fai,” noted L. Charles Landgraf, a partner and insurance regulatory expert at Arnold & Porter LLP in Washington.

“Rather,” said Landgraf, “it talks sensibly about misapprehensions regarding the meaning of that term and then about how the financial system will now be somewhat better regulated. Still, the nature of systemic risk is not discussed, nor is the nature of the companies that might be named SIFIs.”

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