Stephen Foley: Come on, Tim – we're not convinced

US Outlook: If there is one thing that is definitely too big to fail, it is the US Treasury's plans for Wall Street reform. So it was dispiriting that the Obama administration has put forward a proposal with a hole in its heart.

The proposed legislation published this week creates a "third way" for dealing with collapsing companies, so that regulators and politicians are never again faced with the choices of last year, between allowing an uncontrolled bankruptcy (à la Lehman Brothers) or a taxpayer-funded bailout (à la AIG). But the Treasury has botched the central, and the most politically charged, issue – namely, how to pay for it.

This third way is a "resolution authority", overseen by a council of regulators, that allows the unwinding of a failed firm in an orderly fashion. It's a bigger version of the system for seizing retail banks, which is proving invaluable this year. The Federal Deposit Insurance Corporation (FDIC) has seized more than 100 US banks, transferred their good assets to new owners and absorbed losses on the bad assets, all without causing a ripple.

The resolution authority will cover all financial companies deemed too-big-to-fail-in-an-uncontrolled-fashion. That means not just big investment banks but any systemically important firm – which, as we saw last year, might turn out to be an insurance company, or a hedge fund or any other beast created by our innovative financiers. Shareholders can be wiped out, bondholders ordered to take a haircut, management sacked, trading positions transferred and good assets sold.

So far, so consensus. The trouble is that winding down a firm takes money. Even your common or garden industrial bankruptcy usually involves some debtor-in-possession financing, so that the company can keep paying its employees while it restructures. For failing financial firms, deeply intertwined with their peers, the cost of meeting counterparty obligations could quickly run into the billions. This is no small matter to leave unresolved.

Under the Obama plan, the money would come initially from the public purse and be recouped later by a levy on the other companies in the too-big-to-fail category, the "survivors", if you like. Sheila Bair, who heads the FDIC, says it would be better to get all the institutions to pay up front into an insurance fund, the same way the retail banks do. The stubborn Ms Bair once again finds herself taking a harsher tone with Wall Street and on a collision course with the Treasury. Once again, she is right.

It hardly seems fair that the one firm that escapes having to pay into the scheme is the one firm that triggers its use, but that is the least of the problems with an unfunded resolution authority.

The collapse of a systemically important financial firm is hardly likely to be happening in isolation. More likely, it will be in the context of some wider economic calamity or capital market seizure that affects many of its healthier peers, too. The "survivor pays" model implies that these other firms will be tapped for money just when they are trying to rebuild their own balance sheets. They may be survivors, but they are also likely to be walking wounded.

The threat of an onerous levy at that sensitive time could weaken the system further. And these firms' lobbyists might find a sympathetic ear if they ask to be let off the hook – which would mean taxpayers being back on the hook, exactly the outcome everyone is trying to avoid.

A pre-funded scheme also has one wonderful advantage in the present climate. As Wall Street returns to health, it can be presented as a tax on those newly-minted profits, and a means of reducing bonuses.

Tim Geithner, the Treasury Secretary, had a pretty unconvincing answer when lawmakers pressed him on Capitol Hill. A pre-funded scheme, he said, would create "an expectation of explicit insurance" that encourages risky behaviour. Come on, Tim. The US government just spent $700bn bailing out the financial system. That's an expectation that already exists.

It is a mystery why the administration is so adamant against a pre-funded scheme. One can only assume that the Wall Street lobbyists have nobbled it. Why else would the Treasury have a tin ear to the politics of this, to such an extent that it is endangering the whole vital project?