Are big banks doomed to fail?

June 14, 2011, 1:00 PM UTC

FORTUNE — Have you ever watched something unfold, knowing that it hasn’t got a prayer of succeeding?

Then you understand how I feel about the provision in the Dodd-Frank financial reform legislation that would supposedly avoid future federal bailouts by requiring giant financial institutions to draw up so-called living wills.

These “wills,” which banks are currently discussing informally with regulators, are a weak, pathetic substitute for what Washington should have really done: that is, break up “systemically important financial institutions” into much smaller pieces. Or segregate their federally-insured-deposit parts from risky things like creating and trading derivatives. Instead, we have living wills. Translated into English, this means that giant institutions create contingency plans for regulators to break them up or liquidate them in a crisis without any cost to taxpayers. And without the Federal Reserve providing any financing to make the deals work.

Living wills sure sound great. Unfortunately, they can’t possibly work if we have anything resembling the 2008–09 panic, in which financial markets essentially closed down. It’s not just me saying that—lots of players, including the Treasury’s former chief restructuring officer, Jim Millstein, are saying it too. The problem is exacerbated because Dodd-Frank bars the Fed from helping stricken institutions the way it did during the height of the panic. The only financing allowed is from the Federal Deposit Insurance Corp., which isn’t likely to want to take the heat for financing the purchase of stricken institutions’ assets at bargain prices by rich, powerful outfits like Goldman Sachs (GS), J.P. Morgan (JPM), Blackstone (BX), KKR (KKR), or Carlyle.

“There are few, if any, institutions with the balance sheet to support the purchase of one of these businesses in good times,” Millstein says. “In a crisis, when funding in the credit and equity markets is unavailable, no one will be able to do it unless the FDIC supports the purchase with debt and equity financing [which he considers unlikely]. Therefore, there is no credible way to break them up and sell them during a crisis.” Depressing, but true.

The “systemically important institutions” — they’ve not yet been named, but Citigroup (C), Bank of America (BAC), and GE Capital (GE) will clearly be among them — will submit plans to the Fed and the FDIC, which have the power to seize them if they fail to submit a workable will in three attempts.

Millstein and Sheila Bair, the about-to-depart head of the FDIC, are so pessimistic about any plan being workable in a crisis that they told me recently that the Fed and the FDIC should invoke their powers under Dodd-Frank to break up the systemically important firms now. But don’t hold your breath. “I’d be happy to break them up now, but that’s not realistic,” Bair said, “but this is the next best thing.” Even Rep. Barney Frank (D-Mass.) — the Frank in Dodd-Frank — has serious doubts. He told me that living wills are “probably not of use in a crisis, but they’re a useful precrisis tool.”

You can only imagine the uproar if the Fed and FDIC tried to break up an institution for not filing what they consider a workable will. Wall Street would mount a campaign that would make the ferocious attacks against consumer protection chief Elizabeth Warren look like a love pat. It would take about two seconds for Washington to cave in.

If the Fed and FDIC were really, really vigilant, and were really, really willing to take big heat from the Street, they would force some giant institutions to shrink sharply, raise lots more capital, decrease their risk profile, unload problematic businesses, or some combination of these.

But my bet is that after rejecting some wills once or maybe twice, the Fed and FDIC will accept the plans and stick them in a file, allowing life to resume until the next crisis. At which point, today’s restrictions and “no more bailout” vows notwithstanding, Washington will bail out big players again. And the cycle will resume. It was ever thus.

Update, June 16:

I believe Allan Sloan and I were talking past each other when he interviewed me for his column. Perhaps that’s because we spoke on a Sunday evening after dinner and a long work week. In any event, I want to make absolutely clear that I view resolution plans as a vital part of ensuring that the largest financial companies can be resolved in an orderly way, consistent with the process and tools the FDIC has long used to close insured banks. As part of this resolution planning, there may be a need for corporate simplification and restructuring or even divestiture, in order to achieve a viable, credible resolution plan. I understand the sentiment – which he clearly reflects in his column – that we should just “break them up” now, but that is not realistic. However, we do have the tools to make these complex behemoths simplify and rationalize their legal structures with their business lines so that if and when they get into trouble, their individual business units can be quickly broken apart and sold off into the private sector.

I agree that it will take courage on the part of the federal regulators to force structural changes now that will assure smooth resolutions down the road. But I believe both the FDIC and FRB are resolute in ending taxpayer bailouts for good. Dismissing living wills and the “orderly liquidation process” under Dodd-Frank undermines the efforts of the FDIC and other regulators to end Too Big to Fail and provides fodder for the naysayers that have an interest in perpetuating bailouts.

Sheila Bair