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Banks May 6, 2009, 6:12PM EST

Too Big to Fail: Still an Issue

Unless government leaders figure out a way to shrink global finance giants to manageable sizes, taxpayers will surely foot the bill for more bailouts

By Theo Francis, David Henry and Matthew Goldstein

Guy Billout

When Lehman Brothers went bankrupt in September 2008, Washington learned the hard way that some firms are just too tangled up in the global financial system to fail. The government has since doled out $5 trillion to keep the remaining players alive. But mostly policymakers have focused on treating the symptoms of the financial crisis rather than the underlying cause. They've been trying to find the perfect pharmaceutical cocktail, fashioning a mix of programs with offputting names like TALF, TLGP, and PPIP—and changing them on the fly. Some of these plans may relieve the pain, but that's all.

Unless President Barack Obama and other heads of state can figure out a way to bring the global giants of finance down to manageable sizes, taxpayers will surely foot the bill for more bailouts in the future. The task won't be easy. "We will not, in my judgment, eliminate too big to fail," says Gary H. Stern, president of the Federal Reserve Bank of Minneapolis. But he adds: "You want those circumstances to be as limited as possible."

The Obama Administration's main plan for attacking the too-big-to-fail problem calls for giving federal regulators expanded powers to seize and restructure all manner of financial institutions—not just traditional banks—when their failure would threaten the financial system as a whole. In particular, Federal Reserve Chairman Ben Bernanke wants the power extended to include diverse financial giants such as insurance-based conglomerate American International Group (AIG), as well as big holding companies such as Citigroup (C) and Bank of America (BAC), that own both traditional, deposit-taking banks and securities-trading units. But giving federal regulators a greater mandate won't be enough because the giant financial institutions' reach extends around the globe.

Cross-Border Connections

Lehman's collapse spotlighted the byzantine profusion of rules different nations have for handling failed financial companies. For instance, hedge funds that deposited money with Lehman in London are still trying to unfreeze their accounts because Britain doesn't have the same rules for unwinding a brokerage firm as the U.S. Without coordinated efforts, countries could find themselves pitted against one another. "There's a lot of work to do that just hasn't been done," says Sheila Bair, chairman of the Federal Deposit Insurance Corp.

Lehman's failure also revealed surprising cross-border connections between banks. For example, according to a March study by the Bank for International Settlements, in a few frenzied days after Lehman failed, European banks sufferedly badly from $175 billion in withdrawals from U.S. money market funds. The chain reaction was grave because the European banks had gone to the U.S. funds to borrow one-eighth of their dollars. Had the Federal Reserve not backstopped the money markets, a global meltdown almost surely would have resulted.

One solution to the too-global-to-fail problem is old-fashioned trust-busting. Regulators could break off chunks of banks—perhaps also insurers, hedge funds, and others—until those entities fit neatly inside national borders. "Banks that are too big to fail must now be considered too big to exist," says Simon Johnson, a Massachusetts Institute of Technology professor and a former International Monetary Fund chief economist.

Glass-Steagall Reprise?

A step toward that end would be to revive the Glass-Steagall Act, the Depression-era law that barred commercial banks from owning investment banks and other financial firms.

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