Oct. 29 (Bloomberg) -- Federal Deposit Insurance Corp. Chairman Sheila Bair, breaking with the Obama administration, said U.S. financial companies should prepay into a fund the government would use to unwind large failed firms.

Congress should set up a Financial Company Resolution Fund and force institutions with more than $10 billion of assets to pay before a firm collapses, Bair said in testimony prepared for a House Financial Services Committee hearing today. Investors in failed companies also should take losses, she said.

“A prefunded FCRF has significant advantages over an ex- post funded system,” Bair said. “It allows all large firms to pay risk-based assessments into the FCRF, not just the survivors after any resolution, and it avoids the pro-cyclical nature of requiring repayment after a systemic crisis.”

The Treasury Department and House Financial Services Committee Chairman Barney Frank, a Massachusetts Democrat, agreed on compromise legislation this week that would recover from companies with more than $10 billion of assets any costs borne by taxpayers to disassemble a failed firm.

Bair, Treasury Secretary Timothy Geithner, Federal Reserve Governor Daniel Tarullo, Comptroller of the Currency John Dugan and Office of Thrift Supervision Acting Director John Bowman also are testifying. Banking industry representatives also will speak on the draft measure. A similar bill hasn’t been proposed in the Senate.

Geithner endorsed the measure and backed the plan to charge companies to shut down a failed firm after its collapse.

‘Less Moral Hazard’

The draft legislation “would generate less moral hazard because a standing fund would create expectations that the government would step in to protect shareholders and creditors from losses,” Geithner said.

Representative Luis Gutierrez, an Illinois Democrat, sided with Bair.

“Most of us don’t die and then buy a life insurance policy,” Gutierrez said as the hearing began in Washington. “The fund should be set up just in case their reckless behavior, their risky behavior raises its ugly head again.”

The bill “provides a strong framework for achieving a safer, more stable financial system,” Tarullo said in prepared testimony. The bill also gives the Fed power to shrink institutions that could destabilize markets and the economy as lawmakers seek to limit risks posed by large firms.

Regulator Council

The draft legislation creates a council of regulators, including the FDIC, to monitor companies and the economy for systemic risk. While Bair supports the concept, she said the proposed council “currently lacks sufficient authority to effectively address systemic risks.”

Congress should require a presidential appointee as the council’s leader to ensure its independence and set an odd number of members to avoid deadlocks, Bair said.

Frank’s legislation is designed to prevent companies from becoming so large that the government is forced to step in with support to prevent a failure that would shake financial markets. Bair and lawmakers have said a lack of a mechanism for shutting large firms in an orderly way led to ad hoc programs, such as the $700 billion taxpayer bailout used by lenders including Citigroup Inc. and Bank of America Corp.

“Losses should be borne by the stockholders and bondholders of the holding company, and senior management should be replaced,” Bair said in her testimony. “Consideration also should be given to imposing some haircut on secured creditors to promote market discipline.”

The legislation is part of the Obama administration’s plan to overhaul U.S. rules governing Wall Street to prevent a repeat of last year’s financial market collapse, leading to more than $1 trillion in U.S. bailout programs.

Frank’s legislation gives the resolution authority to the FDIC, building on the agency’s existing power to take apart commercial banks and thrifts.

The FDIC is a Washington-based regulator that insures deposits at U.S. banks.

To contact the reporter on this story: Alison Vekshin in Washington at avekshin@bloomberg.net.

Last Updated: October 29, 2009 10:28 EDT