Practically since the day Lehman went down in September 2008 Washington has been conducting a monumental farce. It has been pretending to up-root the causes of the thundering financial crisis which struck that month and to enact measures insuring that it would never happen again. In fact, however, official policy has done just the opposite.

The Fed’s massive money printing campaign has perpetuated and drastically enlarged the Wall Street casino, making the pre-crisis gamblers in CDOs, CDS and other derivatives appear like pikers compared to the present momentum chasing madness. At the same time, the giant regulatory diversion known as Dodd-Frank has actually permitted the TBTF banks to get even bigger and more dangerous.

So now the regulators, who have spent four years stumbling around in the Dodd-Frank puzzle palace confecting thousands of pages of indecipherable regulations, slam their wards for not having sufficiently robust “living wills”. C’mon! This is just another Washington double-shuffle.

The very idea that $2 trillion global banking behemoths like JPMorgan or Bank Of America could be entrusted to write-up standby plans for their own orderly and antiseptic bankruptcy is not only just plain stupid; it also drips with political cynicism and cowardice. If they are too big to fail, they are too big to exist. Period.

Indeed, it is utterly amazing that adult legislators and regulators could even take the idea of a “living will” seriously—-let alone believe that they could possibly thwart the recurrence of another outbreak of so-called “financial contagion”.Yet so thick is the beltway cynicism and so complete is the K-Street domination of policy-making that a trite bureaucratic gimmick like the living will has become a major component of so-called macro-prudential policy.

So there is nothing to do except go back to the fundamentals. First and foremost, the September 2008 meltdown was not a main street banking problem; it was a crisis confined to the canyons of Wall Street, owing to the fact that the gambling houses domiciled there had massively bloated their balance sheets with toxic assets and risky derivatives trades, and then funded these balance sheets leveraged at 30:1 with huge amounts of “hot money” in the form of repo and unsecured wholesale money.

As I demonstrated in the Great Deformation, the “bank run” was almost entirely in the Wall Street wholesale market—there was never any danger of retail runs at the corner branch bank offices, and the overwhelming majority of the 7,000 main street banks did not own the kind of toxic securitized assets that were roiling Wall Street. In fact, the wholesale market runs in the canyons of Wall Street were actually a positive, economically therapeutic event. They had already taken out three of the reckless gambling houses—- Bear Stearns, Lehman and Merrill Lynch—-and were fixing to finish off the remainder, that is, Goldman and Morgan Stanley.

Had the market been allowed to finish off the work of the economic gods in late September 2008, the TBTF problem would have been substantially alleviated.  Today there might have existed a half dozen “sons of Goldman” in the form of M&A, trading, investment banking and asset management boutiques—run by chastened veterans who lost their lunch during the 2008 Wall Street cleansing.

The excuse for the Washington’s massive intervention against the free market in the form of TARP and the Fed’s massive flood of liquidity, of course, is that the US economy was about to be annihilated by something called financial”contagion”.  But that is a specious urban legend invented by the crony capitalists who controlled the Treasury and the money-printers who had fueled the housing and credit bubble at the Fed.

As I have also shown, for example, AIG’s dozens of insurance subsidiaries were money good and would have been protected in bankruptcy by insurance regulators and capital maintenance rules, while the holding company’s fraudulent CDS insurance was parceled out pennies on the dollar by a Chapter 11 judge to the dozen giant global banks who had stupidly attempted to turn toxic CDOs into AAA credits. Likewise, FDIC could have liquidated Citigroup’s regulated bank, while allowing the gamblers who bought stock, bonds and other obligations of the holding company to face their just deserts.

In short, TBTF became a “problem” to be ostensibly remedied with bureaucratic malarkey like living wills primarily because Washington made it a problem by its panicked Wall Street bailouts in the fall of 2008. Indeed, the true solution to TBTF is always and everywhere to allow the free market to cleanse its own excesses and imbalances and impose financial discipline and demise upon reckless gambling and leverage when it is due.

Unfortunately, even if Washington were to refrain from ad hoc bailouts, the free market cure would be perennially compromised by the giant moral hazard posted by deposit insurance and the Fed’s cheap money discount window. Owing to these institutions that systematically encourage excessive gambling by banks, the latter are inherent wards of the state—including the easily abused privilege of fractional reserve banking conferred by state charters.  The right thing to do would be to abolish these sources of moral hazard and tell the K-Street financial industry lobbies to fold up their blush tents because their employers are now all expected to sink or swim on the free market.

Needless to say, the chances that Washington would permit the Wall Street gambling houses to be returned to the unfettered free market that they profess to defend—are somewhere between slim and none. Accordingly, a second best solution is warranted, and it could readily be done.  And it would be far more effective that the lunacy of living wills and all the other bureaucratic  mumbo-jumbo that has some out of Dodd-Frank.

First, re-enact of strict version of Glass Steagall. Only “narrow banks” which take deposits and make consumer and business loans would have access to the Fed’s discount window. By contrast, propriety trading, underwriting, merchant banking, asset management and all the rest of the financial services sectors would be banned at regulated banks and sent back to the free market where they belong.

Secondly, a ceiling on regulated bank size would be established—perhaps measured at 1% of GDP or $200 billion in terms of asset scale.  There are no demonstrated economies of scale in deposit and loan banking above that size, anyway. Stated differently, banks wishing to indulge in the moral hazard of deposit insurance and accessing the Fed’s discount window would not have to prove they were not “too big to fail” or that they had a viable “living will”.  Instead, a TBTF law would do it for them in the form of a statutory cap on the size of regulated banks.

To be sure, Wall Street would scream that such a regime would interfere with the ability of small business and American consumers to get cheap loans. But in a national economy that has gone through a rolling 30-year LBO resulting in $60 trillion of credit market debt outstanding and which sports leverage ratios against income in all sectors that are off the historical charts—that complaint has no merit. Making debt more expensive and permitting it to be economically priced on the free market is, in fact, just what is needed to eventually cure the nation’s debt-ridden economic malaise.

By Ryan Tracy, Victoria McGrane and Christina Rexrode at the Wall Street Journal 

WASHINGTON—In a sweeping rebuke to Wall Street, U.S. regulators said 11 of the nation’s biggest banks haven’t demonstrated they can collapse without causing damaging economic repercussions and ordered them to try again.

The Federal Reserve and the Federal Deposit Insurance Corp. said bankruptcy plans submitted by big banks make “unrealistic or inadequately supported” assumptions and “fail to make, or even to identify, the kinds of changes in firm structure and practices that would be necessary to enhance the prospects for” an orderly failure.

The regulators raised the specter of slapping banks with tougher rules on capital and leverage or restrictions on growth—and even eventually forcibly breaking them up—should they fail to make significant progress to address the shortcomings by July 2015.

The findings applied to 11 banks with assets greater than $250 billion, including Bank of America Corp.,Goldman Sachs,  Bank of New York Mellon…. The firms all received letters detailing shortcomings in their so-called “living wills.”

“Despite the thousands of pages of material these firms submitted, the plans provide no credible or clear path through bankruptcy that doesn’t require unrealistic assumptions and direct or indirect public support,” said Thomas Hoenig, the No. 2 official at the FDIC, in a statement.

Representatives of banks declined to comment or had no immediate comment Tuesday. The Financial Services Forum, a big bank trade group, said banks are safer now than before the crisis and “the industry remains strongly committed to ensuring the financial system is less complex, safe, transparent, accountable and capable of fulfilling its role of promoting economic growth and weathering substantial stress scenarios without taxpayer dollars being at risk.”

The rebuke is almost certain to fuel the debate over whether some firms remain “too big to fail”—or so big their collapse would make government support necessary to avert broad economic damage. It will likely feed the appetite of some lawmakers to push for more aggressive action to force structural changes at the biggest banks.

“Too big to fail is alive and well. The FDIC’s statement that these living wills are not credible means that megabanks will live on taxpayer life support in the event of a crash,” said Sen. Sherrod Brown (D., Ohio), who has proposed legislation to sharply increase capital requirements for the biggest banks, in a statement. He said regulators should use their authority to impose “much higher” capital and leverage rules “sooner rather than later.”

The 2010 Dodd-Frank law required banks to submit an annual “living will” detailing their operations and exposures as well as how they could be dismantled without relying on government support in the event they reach the brink of failure. The requirement was put in place in the wake of the 2008 financial crisis, when regulators struggled to understand the sprawling operations of teetering financial giants such as American International Group and Lehman Bros.

To avoid being hit with tougher rules—or even being required by regulators to break up the company—banks can take steps to make their bankruptcy plans more credible, regulators said Tuesday. These include “establishing a rational and less complex legal structure;” showing they can quickly produce reliable information about their exposures, and amending derivatives contracts to make them easier to bring through bankruptcy.

Only if a bank failed for years to make such changes would regulators conclude that it should be forced to restructure, a Fed official said Tuesday. At that point, the official said, the agencies might seek divestitures that would simplify the firm rather than breaking it up….

Regulators didn’t release details about deficiencies at individual firms Tuesday. Certain banks’ plans have made more progress than others, regulatory officials said on a conference call with reporters.

For months, banks have been asking regulators for specific feedback about their living wills, which they have filed each year since 2012. The banks, which have already submitted their 2014 plans, received no formal individual feedback on any of their submissions until Tuesday.

“The serious problem is that these banks have had no feedback of any material sort” since sending regulators their 2013 living wills last year, said Rodgin Cohen, senior chairman of law firm Sullivan & Cromwell LLP. “It just continues to widen this gulf between the banks and the regulators in terms of communication.”

Part of the delay stemmed from internal debates at the Fed and FDIC about how to respond to firms whose resolution plans may be deficient, people familiar with those discussions have said.

On Tuesday, the FDIC was ready to deal out harsher medicine than the Fed, voting unanimously to find the 11 banks’ plans “not credible.” The Fed’s governing board, headed by Fed Chairwoman Janet Yellen, agreed to order banks to improve their plans but stopped short of using that language. The agencies must agree to call plans “not credible” in order to trigger a legal requirement that a firm immediately resubmit a revised plan and face stiff penalties if regulators remain unconvinced of its feasibility.A Fed official said Tuesday that, while the wording of the findings was different, the agencies agreed to take strong action.

Many observers doubt that the nation’s biggest banks—some with assets greater than $1 trillion—could be put through bankruptcy without broad, negative repercussions. Regulators themselves still haven’t figured out their backup plan: The Fed and the FDIC have endorsed a strategy for preventing panic by keeping a firm’s subsidiaries open while allowing its holding company to fail, but key pieces of that plan remain incomplete.

“I call them regulatory opiates,” Ken Thomas, a Miami-based bank consultant and economist, said of the living wills. “They make the regulators feel good, they make Congress feel good, but what they don’t realize is in the real world, things happen instantaneously, and the time to enact a living will— it doesn’t exist.”

“To sit there and try to come up with a plan to try to orderly unwind a major institution of this size, I don’t know if it can be done,” said Paul Miller, an analyst at FBR Capital Markets and former Fed examiner.

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