July 9 (Bloomberg) -- When Republicans invite a Democrat to testify at a congressional hearing and Democrats invite a Republican, we should pay attention. Such cross-partisan connections aren’t common and typically indicate that congressional leaders are trying to answer difficult questions. That was certainly the case recently, when the House Financial Services Committee held a hearing on how to end “too big to fail.”

Specifically, the topic of the June 26 session was “Examining How the Dodd-Frank Act Could Result in More Taxpayer-Funded Bailouts” -- whether the procedures put in place since 2010 to handle the failure of very large financial institutions would work, and whether we should expect the extraordinary official support provided to those institutions to fade away. The conclusion: The problem of too-big-to-fail banks is alive and well, and looms over our financial future.

In the more optimistic camp was Jeffrey Lacker, president of the Federal Reserve Bank of Richmond. His assessment was that the Dodd-Frank financial reform legislation created sufficient legal powers to tackle the threat of large complex cross-border financial institutions. In particular, he said that regulators would be able to determine when financial companies are too big or otherwise too difficult to resolve through bankruptcy -- and could use Title I powers under the legislation to make banks (and others) small enough and simple enough to fail. This looks like wishful thinking.

Vietnam Syndrome

In the 2004 documentary, “Fog of War,” former Defense Secretary Robert McNamara talked at length about how decisions were made in the early years of the U.S. involvement in Vietnam. In any situation with imperfect flows of information, the mindset of the receiver is critical. If you think that things are going well, it is easy to put a positive spin on even the most adverse events.

Most people at top levels of the Fed seem to have a broadly positive view of the financial sector today: Everything is moving in the right direction and anyone who thinks otherwise is being too negative or even undermining the home team.

Richard Fisher, president of the Dallas Fed, is a welcome exception among central bank officials. He has extensive experience in the private sector and understands how highly leveraged situations can unwind in brutal fashion. His testimony on the current situation was uncompromising: “Less than a dozen of the largest and most complex banks are each capable -- through a series of missteps by their management -- of seriously damaging the vitality, resilience and prosperity that has personified the U.S. economy.”

Fisher and his colleagues at the Dallas Fed find that large financial institutions receive big implicit subsidies (see Page 6 of his testimony).

Sheila Bair, former chairman of the Federal Deposit Insurance Corp., was surely right to say that Dodd-Frank created some important new legal powers that can be used to resolve failing financial institutions. (Bair is the Republican who was called to testify by Democrats, and Fisher is the Democrat who was called by Republicans).

But over the past three years, has there been any indication that top regulators can see through the fog of finance and actually apply the powers available under Dodd-Frank? I am increasingly pessimistic. (Bair chairs the private sector Systemic Risk Council, to which I belong, and we do our best to press regulators to move in the right direction, despite enormous opposition from the industry.)

‘Safety Net’

As Tom Hoenig, the current FDIC vice chairman, put it at the hearing: “Short-term depositors and creditors continue to look to governments to assure repayment rather than to the strength of the firms’ balance sheets and capital. As a result, these companies are able to borrow more at lower costs than they otherwise could, and thus they are able increase their leverage far beyond what the market would otherwise permit. Their relative lower cost of capital also enables them to price their products more favorably than firms outside of the safety net can do.”

Unfortunately, the Fed’s Board of Governors seems unable to state the problem as clearly. And without the Fed Board, there is very little chance of progress within the existing Dodd-Frank framework.

In the absence of further legislative instruction, reform is stuck. The regulators could make use of their existing powers to do more, but they won’t. The last three years have taught us this.

Very large financial companies are likely to be rescued in future crises; the credit markets take this into effect when providing funding.

Fisher strongly advises that further steps be taken to make the banks simple enough and small enough to fail. He has some practical suggestions, such as limiting the official safety net to traditional commercial banking, while forcing everyone engaged in lending to higher risk trading or investment banking to acknowledge they have no downside protection from the government.

We desperately need strong voices on Capitol Hill, both Republicans and Democrats, to take up these ideas. Putting this kind of pressure on regulators is the only way to make the financial system significantly safer.

(Simon Johnson, a professor at the MIT Sloan School of Management as well as a senior fellow at the Peterson Institute for International Economics, is co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”)

To contact the writer of this article: Simon Johnson at sjohnson@mit.edu.

To contact the editor responsible for this article: Max Berley at mberley@bloomberg.net.