Nov. 25 (Bloomberg) -- Ever since the Great Depression, regulators have tried to prevent bank runs. As Congress inches toward financial reform, it is failing to address the modern equivalent of this old problem: runs on the market.

That, after all, is what brought the financial system and global economy to its knees over the past two years. Investors and banks refused to buy debt or provide credit until governments stepped in and backstopped markets.

The major competing financial-reform proposals being battled over in Congress either ignore this problem or might make it worse, if and when future meltdowns occur. In that case, taxpayers will again face a choice of allowing financial catastrophe or funding bailouts of too-big-to- fail firms.

The flaw in congressional thinking is the notion that it is possible to deal with too-big-to-fail firms when they are on the verge of collapse. It isn’t. By that point, investors will be racing to pull their investments.

And since markets, just like too-big-to-fail firms, are so tightly intertwined, there will be runs in places officials don’t expect. That was one lesson of the collapse of Lehman Brothers Holdings Inc., which unexpectedly panicked holders of money-market funds.

Although banks and politicians say they want a system that permits big institutions to fail, in reality there is now a No- More-Lehmans mindset that makes failure not an option. So long as too-big-to-fail firms exist in their present form, the next time trouble hits, Wall Street will again win out over taxpayers.

Band-Aid Approach

Bills being pushed by House Financial Services Committee Chairman Barney Frank and Senate Banking Committee Chairman Christopher Dodd fail to deal forcibly enough with this issue. They address the too-big-to-fail firms with Band-Aids and don’t force these firms to shrink.

The Frank legislation, as amended by the committee, may force other financial institutions to shoulder the cost of winding down a fallen peer; require bondholders and secured lenders to take losses when the government has to seize an institution; and allow regulators to seize seemingly healthy firms if they may pose a risk to the system.

None of those approaches go far enough. Dodd’s bill in the Senate, which isn’t as far along the legislative process as Frank’s, is equally palliative toward the problem.

Intentions and Reality

Many of the proposals are well-intentioned. Financial institutions should pay to shore up the system that allows them to generate profit. Debt investors in banks shouldn’t be shielded from the pain of failure.

What is good in theory often doesn’t work in practice, though. The reality is that investors and institutions sensing trouble will pull their money, especially if there are programs in place that may force losses on them.

And they won’t flee just one institution; they will run from all. That would be especially true if regulators seize a seemingly healthy firm, calling into question the health of every other firm.

If such a run ensues, this will trump the goal espoused by Congress, and endorsed in a letter by Federal Deposit Insurance Corp. Chairman Sheila Bair, to prevent taxpayers from funding bailouts by forcing losses on creditors.

To really deal with this, Congress needs to think more about how the government stopped bank runs in the wake of the Great Depression.

Unfortunately, the main tool, deposit insurance, isn’t a practical solution. A too-big-to-fail insurance fund won’t work if it isn’t funded up-front. And even if it is, it would likely be too small if multiple failures occur. Keep in mind that the government has committed almost $400 billion in potential funding just to keep afloat three institutions --American International Group Inc., Fannie Mae and Freddie Mac.

Taxpayer Support

More important, any insurance fund, like that run by the FDIC, must be backed by the Treasury Department and, by extension, taxpayers. While taxpayers are willing to stand behind small bank depositors, aka Mom and Pop, it’s doubtful they would back big banks.

A second post-Depression reform that may be more relevant to today’s issues is the cap prohibiting any individual bank from having more than 10 percent of overall national deposits. Yes, the cap has sometimes hampered bank growth and forced institutions to shed operations. Still, banks learned to grudgingly live with it.

The same approach should be taken today when it comes to firms’ control of vast swathes of capital markets, their links to one another and the conflicts within their own businesses that stir concerns for the safety of the financial system.

Those conditions have to be eliminated, and the only way is to force banks to shrink. Separating commercial and investment banking activity is an obvious first step. So too is dividing proprietary trading, brokerage activities and fund management.

Derivatives Market

An example of an area ripe for action is the over-the- counter derivatives market, which globally has a notional value outstanding, or face value, of about $600 trillion. Five of the top 25 U.S. bank-holding companies -- JPMorgan Chase & Co., Bank of America Corp., Goldman Sachs Group Inc., Morgan Stanley and Citigroup Inc. -- account for about $278 trillion of total notional derivatives, according to the Office for the Comptroller of the Currency.

Clearly, none of these firms can be allowed to fail, or possibly be closed down in a controlled way. Either would prompt a run on derivatives markets and by extension other debt markets.

There is no getting around the reality that too- interconnected-to-fail firms need to be undone if taxpayers are to be spared future bailouts. Reform legislation needs to do just that.

(David Reilly is a Bloomberg News columnist. The opinions expressed are his own.)

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To contact the writer of this column: David Reilly at dreilly14@bloomberg.net

Last Updated: November 24, 2009 21:00 EST