July 15 (Bloomberg) -- Federal Deposit Insurance Corp. Chairman Sheila Bair, with support from Federal Reserve officials, is pushing for tougher measures to curb the size and risk-taking of the nation’s largest financial firms.

The FDIC will propose slapping fees on the biggest bank holding companies to the extent that they carry on activities, such as proprietary trading, outside of traditional lending. The idea goes beyond the Obama administration’s regulation-overhaul plan, which would have the Fed adjust capital and liquidity standards for the biggest firms, without any pre-set fees.

“What we have suggested is financial disincentives for size and complexity,” Bair said in a July 9 interview. Fed Chairman Ben S. Bernanke told lawmakers last month that restricting size is a “legitimate” option.

Size limits would overturn decades of regulatory tradition that promoted the view that large, diversified institutions were more immune to risks when specific industries or regions slumped.

Bair’s proposal is another chapter in the clashes she’s had with Treasury Secretary Timothy Geithner and his department over dealing with banks and the financial crisis.

Special fees could hit firms such as Bank of America Corp., JPMorgan Chase & Co. and Citigroup Inc. that expanded beyond traditional lending and deposit-taking.

Products Affected

The fees would go to a reserve fund for rescues of bank holding companies, modeled on the FDIC’s deposit-insurance fund. They would target risky assets, such as structured products, over-the-counter derivatives and assets kept off of balance sheets.

“This is a sharp about-face in how the supervisors are looking at risks in these banks,” said Dino Kos, a managing director at Portales Partners LLC and former markets director at the Federal Reserve Bank of New York. Limiting size “is a valid debate.”

Minneapolis Fed President Gary Stern has also favored expanded FDIC powers to levy premiums on large, complex financial firms and tougher merger reviews where risks posed to the banking system are an “explicit consideration.”

The Treasury’s plan would tax financial firms only after bailouts occurred, reflecting concern that a pre-funded bailout reserve would worsen moral hazard, making the firms confident of a rescue in case their bets go wrong.

Big Get Bigger

The crisis has made some firms even bigger, as regulators endorsed or encouraged mergers of weaker lenders with firms perceived to be better able to weather the turmoil. Bank of America, the Charlotte, North Carolina-based firm that is the biggest U.S. bank by assets and deposits, absorbed Merrill Lynch & Co. last year.

“The benefits to society of economies of scale and economies of scope can’t possibly pay for the costs that we pay when they fail,” said Fed historian and Carnegie Mellon University Professor Allan Meltzer in an interview.

The FDIC suggestion follows quarrels between Bair and Geithner, who’s leading the administration’s financial- regulation overhaul initiative, and his predecessor, Henry Paulson.

Bair pushed the Treasury to use more of its $700 billion financial-rescue fund to help prevent mortgage foreclosures, and dropped support for a Treasury-led plan to merge Citigroup and Wachovia Corp. last year. Geithner sought to push Bair out after the November presidential election, people familiar with the matter said last year, before lawmaker support encouraged President Barack Obama to let her remain in office.

JPMorgan Strength

Size hasn’t always defined systemic risk. Bear Stearns Cos. had $399 billion in total assets at the end of February last year before it had to be rescued by JPMorgan -- a larger firm with about $2 trillion in assets that had the management capability and financial strength to absorb the investment bank.

Even so, regulators, lawmakers and economists are rethinking the benefits of letting large financial companies merge, acquire or borrow their way to greater size after what may become the costliest bank-rescue campaign in history. The FDIC has lost more than $39 billion from its deposit-insurance fund since the start of last year as it wound down failed banks.

House Financial Services Committee Chairman Barney Frank plans a hearing on the so-called too-big-to-fail issue July 21. “What we want to come out of this with is a substantial diminution at the very least of that problem,” said Frank, a Massachusetts Democrat.

Obama Plan

The Obama administration’s proposal would allow financial institutions to continue to expand so long as they meet capital and liquidity requirements set with discretion by the Fed after discussions with other agencies.

The Obama plan has come under attack in Congress, where legislators have expressed skepticism about giving the central bank more powers in the aftermath of the Fed’s failure to avert the mortgage crisis.

Stern, the outgoing Minneapolis Fed chief, said this month the Obama proposal “leaves the financial system considerably more vulnerable” and inadequately addresses the too-big-to-fail issue.

“There is nothing in the Treasury proposal designed to put creditors of large, systemically important financial institutions at risk of loss,” Stern said in a July 9 speech in Helena, Montana. Bair also favors making explicit the losses for shareholders and creditors of firms that seek federal aid.

“A financial system characterized by a handful of giant institutions with global reach and a single regulator is making a huge bet that those few banks and their regulator over a long period of time will always make the right decisions,” Bair told the Senate Banking Committee in May.

To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.net; Alison Vekshin in Washington at avekshin@bloomberg.net

Last Updated: July 15, 2009 11:58 EDT