Volcker: Risk of 'too big to fail' remains

updated 3:22 p.m. ET Sept. 24, 2009

WASHINGTON - A top White House economic adviser says the Obama administration’s proposed overhaul of financial rules preserves the policy of “too big to fail,” and could lead to future bailouts.

Former Federal Reserve Chairman Paul Volcker said Thursday that by designating some companies as critical to the broader financial system, the plans create an expectation that those firms enjoy government backing in tough times. That implies those financial companies “will be sheltered by access to a federal safety net,” he said.

Lawmakers should make clear that nonbank companies will not be saved with federal money, he said.

Emergency measures by the Fed, Treasury and Congress during last year’s financial crisis created the expectation that the government would step in to protect failing companies, their bond holders and stockholders, Volcker told the House Financial Services Committee.

Volcker said he does not differ with the administration on most of its proposals, and takes “as a given” that banks will be bailed out in times of crisis.

But he opposed bailouts of insurance firms like American International Group Inc., automakers’ finance arms and others.

“The safety net has been extended outside the banking system,” Volcker said. “That’s what I want to change.” He said the administration’s proposal to create a new system for winding down large nonbank companies would make that easier.

The administration should make it clearer that a “safety net” will apply only to traditional banks, not investment companies or others. Investors must understand that if a nonbank company fails, stockholders and bondholders’ money would be at risk, he added, while endorsing other options for these companies, including forced mergers or liquidation.

Deputy Treasury Secretary Neal Wolin said the administration’s proposals are intended to emphasize “that being among the largest, most interconnected firms does not come with any guarantee of (government) support in times of stress.”

The administration’s goal is to strengthen the financial system through measures such as requiring banks to hold more capital in reserve and tightening oversight of derivatives. That will make it easier for the financial system to “absorb the failure” of a large firm without government help, Wolin said Thursday.

“The central objective, again, is to make the system strong enough so we can allow failure to happen in a way that doesn’t cause enormous collateral damage to the economy and to the taxpayer,” Treasury Secretary Timothy Geithner told lawmakers Wednesday.

Volcker, 81, has emerged as one of the administration’s internal critics. He serves as head of President Barack Obama’s Economic Recovery Advisory Board, but has said the administration should take a slower, more methodical approach to overhauling the financial system.

Volcker served as Fed chairman from 1979 to 1987, when he tamed raging inflation, though at the cost of painful interest rate hikes that triggered a recession.

In recent speeches, he has expressed little enthusiasm for some of the initiatives under discussion in Washington, including regulating bankers’ compensation. He has said there is “ample justification” for public anger at pay practices that were “wildly excessive” and encouraged risk-taking at the expense of stability. But he warned against too much political involvement.

In his remarks Thursday, Volcker endorsed a stricter separation between banks that hold deposits and investment banks. He said the “safety net” should be limited clearly to commercial banks, while investment banks should be excluded.

“Commercial banks are the indispensable backbone of the financial system,” Volcker said, giving consumers safe deposit accounts and financial advice.

MORE FROM U.S. BUSINESS

U.S. business Section Front

NASCAR sponsors seem to be in driver’s seat Japan Airlines keeps alliance with American Winter athletes fight to get day in sun   Golden opportunities: Turn gold into green Little-guy sponsors score Olympic talent Doritos’ ‘House Rules’ ad is tops with users The best and worst of Super Bowl ads Magazine circulation falls 9 percent in U.S. Restructuring CIT taps ex-Merrill chief as CEO Super Bowl goes into overtime, with the ads U.S. business Section Front   Add U.S. business headlines to your news reader: