Commentary: Getting it right the next time on "too big to fail"

-- Cornelius Hurley is a professor and director of the Morin Center for Banking and Financial Law at the Boston University School of Law. The opinions expressed here are his own --

By Cornelius Hurley

BOSTON (Reuters.com) The Great Bailout of '08 is a stop-gap measure specifically designed to avoid an economic calamity. But going forward, we must define explicitly what "too big to fail" means and designate ahead of time the specific firms that meet that definition.

Once a firm is pegged as TBTF, there is a commonality of interests between it and the public sector such that the information available to its regulator is absolute. Being "too big to fail," of course, gives an organization a price advantage over its competitors in the credit markets. That advantage is measurable and should be returned to the government in the form of a tax or a premium.

Define, inform, and price -- these should be the action words that shape the new regulatory structure at the highest policy level.

Define - The deregulatory hubris of the past decade has brought forth companies of a scale and scope difficult to comprehend let alone manage. Technological advances, financial engineering, and the evisceration of antitrust enforcement have driven the trend.

But none of it would have been possible without the government's deliberate ambiguity about when and under what circumstances it would come to the rescue of these giants. No better example exists than that of Fannie and Freddie whose very business models were built upon this ambiguity.

To save us from ourselves, it falls to the Fed, as the most logical of the current governmental bodies, to decide in advance which organizations are and are not "too big to fail." Of course, size matters but it is not the only measure. Complexity, interconnectedness, transparency, and governance structures all come into play.

Some organizations will embrace this designation while others will flee from it. For others, a tap on the shoulder by the Fed may be the occasion for divestitures or an exit from a business line that they are ill equipped to control so as to avoid the TBTF label. Better to clarify these issues on the front end than as part of a Fed/Treasury auction.

Inform - If an organization is to enjoy the privilege of the taxpayers back-stopping its debt obligations then surely the informational intimacy between it and the government should be intense. No more "requests" for documents, no more off-balance sheet SIVs, no more incomprehensible financial products.

Recall that at the Bailey Savings and Loan in Capra's It's a Wonderful Life, it was the simple presence of bank examiner Carter not Uncle Billy's misplaced deposit that caused the truth to out. In the new world order of TBTF companies there will be a premium on truth.

Price - Of course, the womb of government protection will be a very comfortable place. Debt financing, as contrasted with equity, will be cheap. This government subsidy should not be transferred to the shareholders. Rather, it should be treated as a cost of doing business, an insurance premium if you prefer, and be paid directly to the Fed because, as we have learned lately, even companies that are "too big to fail" sometimes do so.

Viewed from 50,000 feet, what the bailout bill represents is our government's capitulation to its own inability to reach a coherent policy on TBTF. The policy Treasury and the Fed have adopted is that the entire system is too big to fail. This may be the only option available in the current circumstances, but it is hardly the roadmap for a new era.