Liquidation Power Difficult to Implement

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Will the U.S. government ever use its new power to break up large failing financial firms? Even top members of an advisory panel acknowledge the widespread skepticism.

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The belief that large financial firms remain too big to fail, despite regulators' vows to avoid a repeat of 2008's taxpayer bailouts, is part of the problem regulators are trying to crack.

``Nobody believes it, some people believe it, but not many people believe it,'' said former U.S. Federal Reserve Chairman Paul Volcker, a member of the 19-member panel that met for the first time on Tuesday. ``That's where your problem is.''

Until investors believe liquidation is a possibility, the largest financial institutions will continue to enjoy cheaper costs of capital and may be tempted to take greater risks.

Authorized by last year's Dodd-Frank law, the Federal Deposit Insurance Corp and the Fed are still drafting the rules for how this resolution process will work, including how creditors will be treated.

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It aims to avoid a repeat of massive government bailouts during the 2007-2009 financial crisis, such as the more than $80 billion in taxpayer support for insurer AIG <AIG.N>, and destructive bankruptcies like Lehman Brothers <LEHMQ.PK>.

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Members of the FDIC advisory committee said regulators will have a difficult time convincing financial markets that despite these new powers the government will not ultimately step in to bail out a large bank or other financial firm.

``I think until you actually do it... it's not going to be widely believed,'' said Richard Herring, finance professor at University of Pennsylvania's Wharton School.

Regulators, including FDIC Chairman Sheila Bair, have acknowledged this skepticism but have argued that markets need to understand that the Dodd-Frank law prevents the government from stepping in and that Congress would have to change the law for taxpayer funds to flow to failing institutions.

Bair also said regulators will not be able to prevent all problems. ``You'll always have some boneheads that will fail,'' she joked.

As part of the new resolution powers the FDIC and the Fed will require large financial firms to write ``living wills'' outlining how they could be broken up if they fail. The first drafts of these plans are expected to be submitted to regulators toward the end of the year.

If regulators are not satisfied with the plans they can force institutions to realign their business lines and create foreign subsidiaries so they are easier to break up.

John Reed, the former chairman of Citigroup, said regulators intent to have boards involved in approving living wills will give them an incentive to make sure they are credible.

Panel members, however, said it will be difficult for large, internationally active banks to write credible plans and for regulators to use them because different parts of their business fall under the supervision of more than one country.

``These are global banks with a great deal of liabilities off shore,'' said former IMF Chief Economist Simon Johnson. ''Internationally you are going to have a very hard time getting the British, the Koreans or the Chinese to cancel on their creditors.''

Other advisory panel members include former Fed Vice Chairman Donald Kohn, former Securities and Exchange Commission Chairman William Donaldson and prominent bank lawyer Rodgin Cohen, a partner at Sullivan & Cromwell.