White House to Big Banks: You're Not Too Big to Fail

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Perhaps floating a trial balloon straight from the oval office, a key economic adviser to President Obama warned large banks that nobody is immune to government closure — and that the U.S. needs a government arbitrator with the power to shut down banks that pose a “moral hazard.”

That message comes from former Federal Reserve Chairman Paul Volcker, now the head of President Obama’s economic recovery panel. In a speech last week in Washington D.C. at the Peterson Institute for International Economics, Volcker said that all efforts will be made by the federal government to support U.S. financial institutions, but in the end, Uncle Sam must have the power to pull the plug on big banks and insurance companies.

Said Volcker; “The overwhelming factor of the recent crisis was that creditors were largely protected and government support — and here is where we get to the real point of my concerns — government support was provided to non-banks in actually much more radical ways than to commercial banks, to investment banks, to the world's largest insurance companies, and to the commercial paper market itself. Money market mutual funds, their very existence is dependent upon regulatory arbitrage, where if they got in trouble, we'll protect it.”

He adds; “Now, the result is moral hazard gets large. There is an expectation that very large and complicated financial institutions will not be allowed to fail. Creditors, managers, even stockholders need to be protected in a time of crisis. And unless that conviction is shaken, the natural result is that risk taking will be encouraged and, in fact, subsidized beyond reasonable limits and we may be at it full speed to the next crisis some years ahead. But that seems to me to really be the core challenge of financial reform in the United States and elsewhere as well.”

Volcker’s message to the IIE has been interpreted in the last week by economists and by the business media as a warning shot to big financial institutions. "There is a clear need for a so-called resolution authority," Volcker told his audience. In other words, just because Uncle Sam bailed out AIG (Stock Quote: AIG) doesn’t mean every big bank or insurance company will get the same treatment if they're in trouble.

Consequently, if banks continue to engage in high-risk investment programs, they shouldn’t expect a government safety net — even if it means they fail.

Thus the importance of the “moral hazard” comment. Sure, it may not go down in history like former Fed chief Alan Greenspan’s “irrational exuberance” comment, but big banks better take heed.

Just because you believe you’re too big to fail, that doesn’t mean you’re not too big to fail — at least to the powers-that-be in Washington D.C.

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