Since the first, dramatic interventions into the financial system by the Treasury Department and the Federal Reserve during the collapse of Bear Stearns a year ago, Timothy Geithner has based his approach on one underlying theory. The crisis, the former New York Fed president and now Treasury Secretary believes, is the result of the collapse of a shadow banking system that grew over the past 30 years to rival the traditional banking system in size but lacked all four of the safeguards that had been imposed after repeated collapses of the traditional system in the early part of the 20th century.
Geithner, his predecessor Hank Paulson, FDIC chief Sheila Bair and Fed Chairman Ben Bernanke have so far used ad hoc powers to erect two of those crucial four pillars. Last fall they introduced Fed-sponsored insurance for money-market deposits, the equivalent of the FDIC insurance that exists for regular bank accounts. At the same time, they opened Fed lending to financial-services companies, making the Fed the lender of last resort for those firms, just as it is for traditional banks. In the past two days, Geithner unveiled the final two safeguards that he, Bernanke and Bair believe will help to prevent a future widespread financial meltdown: the power to take control of collapsing companies to ensure their failure is orderly and not contagious, and a limit to the amount of risk and leverage that non-bank financial players can take on. (Read TIME's Q&A with Sheila Bair.)
The power to seize financial firms that are on the verge of collapse is already the most controversial new provision. Under Geithner's plan, the companies would have to be so big and in such bad shape that their insolvency could threaten the financial stability of the U.S.; if they are, the boards of the FDIC and the Federal Reserve, in consultation with the Treasury Secretary, could decide either to bolster them with financial assistance or to seize them and break them into parts.
"Do you realize how radical your proposal is?" Republican Congressman Donald Manzullo of Illinois asked Geithner during an appearance Thursday in front of the House Financial Services Committee. "You're talking about seizing private businesses."
Geithner argued that the power is needed to ensure that a floundering firm doesn't start a domino collapse among other companies doing business with it, thereby posing what regulators call "systemic risk" to the whole economy. "This is a prudent, carefully designed proposal to protect our financial system," Geithner said, arguing that if Treasury had had that power a year ago, it could have handled the collapses of Bear Stearns, Lehman and AIG very differently. Other Democrats said the power isn't so radical at all; the FDIC already takes over traditional banks on the verge of collapse when the agency decides a firm is on the brink, it steps in, cleans it up and then turns it loose. (Read about AIG's deep impact.)
Though politicians on Capitol Hill have made less of it thus far, the other change that Geithner is seeking is even farther-reaching and arguably more controversial on Wall Street. As banks must do now, big hedge funds, private equity firms, insurance companies and others who play in the financial markets would have to open their books (on a confidential basis) regularly to government overseers. Hand in hand with that requirement would be much tougher limits on how much risk any financial firm could take, so that the days of making huge bets on the markets with relatively little in capital to back them up would be no more. And Geithner's plan would also for the first time subject exotic financial-derivative products, like the credit-default swaps that took down AIG, to federal oversight and market transparency.
"Let me be clear," Geithner told the committee. "The days when a major insurance company could bet the house on credit-default swaps with no one watching and no credible backing to protect the company or taxpayers must end."
For all the complaining, Geithner is likely to get much of the authority he wants. The power he is asking for could be invoked only under explicitly prescribed circumstances, similar to those imposed by Republicans on the FDIC in the early '90s, when it takes dramatic action in case of major banking crises. Though industry officials may gripe, Geithner's fixes are little different from the rules that traditional banks already abide by (and make plenty of profits under). And even the GOP might not have as many philosphical objections as one would expect. On the same day that Geithner rolled out his proposals, House Republicans expressed support for a step the Obama Administration has so far resisted: turning to the FDIC, or an entity like the Resolution Trust Corporation used during the savings-and-loan crisis, to temporarily take over today's failing big financial companies loaded down with toxic assets.