Partisan schisms aside, financial regulatory reform must get done.

Friday, April 16, 2010; A24

FINANCIAL regulatory reform is necessary, complex -- and easily demagogued. Thus, although Republicans and Democrats in the Senate did, for a time, engage in negotiations, the odds never favored calm, bipartisan lawmaking. Add massive lobbying and a polarized pre-election political climate, and what you get is the populist posturing of the past week. Senate Minority Leader Mitch McConnell (R-Ky.) denounced a bill backed by the Obama administration, saying it "institutionalizes" taxpayer-funded bailouts. The bill's author, Banking Committee Chairman Sen. Christopher J. Dodd (D-Conn.), called the GOP line a Wall Street-inspired "falsehood."

What are the merits of the dispute? No one wants a repeat of 2008, when Lehman Brothers and American International Group reached the brink of failure and the government lacked a clear legal alternative to their bankruptcy: AIG got an improvised and expensive taxpayer bailout; Lehman was allowed to collapse, triggering global panic. To keep something similar from happening, Mr. Dodd would empower regulators to name systemically risky institutions, whether banks or nonbanks, and require them to hold more capital and create a Wall Street-paid $50 billion resolution fund that the Federal Deposit Insurance Corp. could use to liquidate a big insolvent firm.

To the extent that this establishes a permanent category of systemically important -- "too big to fail" -- firms, along with a means to wind them up, Mr. McConnell is partly right. In addition to bankruptcy court, executive-branch resolution of creditors' claims against certain big distressed companies would become an acknowledged, long-term option in American capitalism. The risks are exactly the ones that Mr. McConnell identifies. Creditors might fund systemically important firms on artificially advantageous terms, thus enabling them to grow bigger and riskier. Some House Democrats made this very point when a similar bill was before them last fall, and they insisted on amendments to address it.

Yes, Wall Street would provide the $50 billion fund, so it's true, as Mr. Dodd insisted, that his bill contemplates no taxpayer bailouts. But of course the big banks would find some way to pass that cost along. And what if markets see the $50 billion as the minimum federal commitment, not the maximum? Would taxpayers face exposure then? Treasury Secretary Timothy F. Geithner raised this concern last October, telling a House committee: "You're going to create more moral hazard; people will have the expectation that the government will come in and protect them." He favored collecting the money after a firm's collapse but lost the policy argument.

The problem with Mr. McConnell's contention -- and it's a large one -- is this: What's the alternative? Ideally, reckless firms go bankrupt, their competitors pick up the pieces, and the economy, chastened and more efficient, marches on. Realistically, certain financial institutions get so big and so interconnected that their collapse threatens more short-term damage than society can withstand. Throughout recent history, government repeatedly has bailed out firms for this reason -- Mr. McConnell himself courageously supported a $700 billion fund in 2008.

The Dodd bill represents a bet that it is better to acknowledge these realities, and consciously shape them, than to pretend they can be avoided altogether. It's hard to imagine that any firm would intentionally manage itself into a process that ends with shareholders wiped out, management fired and creditors collecting pennies on the dollar, as the bill requires. The bill imposes tighter regulations and higher capital requirements to make it less likely that a bailout would be necessary in the first place. That is, if the bill creates certain artificial advantages for big firms, it also at least tries to counteract them.

Speaking of ideals vs. realities, in an ideal world Senate Republicans and Democrats, and the administration, would be willing to acknowledge the tradeoffs inherent in any effort to get this issue right and incorporate one another's legitimate arguments in a serious effort to produce a bill. Sen. Bob Corker of Tennessee, a Republican who has negotiated with Democrats on the Banking Committee, says genuine differences on "too big to fail" could be worked out "in five minutes." Any takers?

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