Proposed solutions run the gamut from higher capital and liquidity requirements for large and complex banking companies — as well as enhanced oversight — to higher taxes and curbs on growth and risk-taking. While there is no doubt that such moves would soften the blow if a behemoth fell, none would eliminate the problem.
"It's naive to think 'too big to fail' is going to go away," said Gil Schwartz, a partner at Schwartz & Ballen LLP. Regulatory reform "may change the nature of the problem, but I don't think it will ever go away. It will always lurk in the shadows that an institution is too big to fail and the government won't let it fail."
The notion that certain banks are too big to fail has been around for a long time, at least since the rescue of Continental Illinois in 1984.
But it has never been as contentious as it is now, largely because the government spent hundreds of billions of taxpayer dollars to save some of the biggest banking companies in the wake of the financial crisis.
"The magnitude of the government aid in this situation has certainly made it far more difficult to have a credible position in the future that the government won't stand behind them," said Cornelius Hurley, a professor at Boston University School of Law.
Though the entire regulatory reform campaign, which began in earnest last June, has been billed as a way to end the de facto policy of too big to fail, the debate has veered to other issues, including ways to improve consumer protections and consolidate banking supervisory agencies.
The most recent direct attack on too big to fail is the so-called Volcker Rule, which would ban commercial banks from trading for their own account or owning or investing in hedge funds and private-equity pools. It would also limit overall size by means of a to-be-determined liability cap.
"Never again will the American taxpayer be held hostage by a bank that is too big to fail," President Obama said in announcing the plan on Jan. 21.
But observers said the plan, named after former Federal Reserve Board chairman Paul Volcker, who is now an economic adviser to the president, does not come close to solving the problem.
Though the proposed proprietary trading and activities ban could conceivably mean that some large institutions would have to divest or restructure securities units, not every banking company considered too big to fail does a significant amount of proprietary trading, including JPMorgan Chase & Co. [JPM]
The proposed size limits, meanwhile, would apply only to future growth; they would not curtail institutions' current size.
"This new financial-sector size limit should not require existing firms to divest operations," Neal Wolin, the Treasury deputy secretary, testified at a Senate Banking Committee hearing last week. "But it should serve as a constraint on future excessive consolidation among our major financial firms … . It should constrain the capacity of our very largest financial firms to grow by acquisition."
Sen. Jim Bunning, R-Ky., pointed out that, by targeting only future growth, the plan ignores current realities.
"If these firms are already too big to fail, and the last two years have shown that at least in the judgment of the Federal Reserve and Treasury that is the case, why should we not force them to get smaller in addition to stronger regulations?" Bunning asked. "How does letting a firm that is already too big to fail stay big … how does it solve the problem?"
Sen. Robert Menendez, D-N.J., agreed. "You know, in the wake of the financial crisis, the surviving banks have actually grown bigger, not smaller," he said. "The Volcker Rule doesn't force existing banks to downsize."
Some regulators, however, said restrictions on risk-taking would help. New York Banking Superintendent Richard Neiman said that, if the ban on trading and dealing with hedge funds were applied retroactively, institutions would be safer and less likely to fail (and therefore less likely to need a bailout).
"It reduces the likelihood of failure by curtailing speculative activities," Neiman said. "To the same extent, it could prevent the growth of institutions to the extent they are being driven by those activities."
Some observers pointed to another proposal designed to curb the problem. An amendment in the House regulatory reform bill by Rep. Paul Kanjorksi, D-Pa., would let a new council of regulators, working with the Fed, break up healthy companies that pose a risk to the system.