The public remains obsessed with ending “too big to fail,” the unstated policy in which the federal government rescues the biggest banks to prevent financial disaster. With the imminent retirement of U.S Treasury Secretary Timothy Geithner, who masterminded bailouts while serving as New York Federal Reserve president and later at Treasury, bloggers are firing up another rhetorical fusillade against the Geithner-era bailouts.
The anger is misdirected. For one thing, most of the bailouts consisted of loans on which the government and taxpayers will earn a profit. And the bailouts were, in general, the least bad of all possible options.
Ordinary Americans suffered far more because we had a crisis, not because bailouts were among the remedies for ending it. People were hurt, that is, because the economy went south, jobs and decent wages disappeared, and the stock market and home values tanked.
Minimizing the likelihood of bailouts is important, but not because they became a symbol of popular frustration. It’s important because, in a few specific circumstances, the possibility of a bailout later may induce risky behavior now and bring on the next crisis. This isn’t true of the programs that people commonly object to, such as the Troubled Asset Relief Program or the loans to American International Group Inc. TARP severely diluted shareholders of weak banks, and those of AIG were wiped out.
No law can eliminate the possibility of a future TARP-style rescue. Crises, by their nature, tend to surprise, and surprises lead to panic. The officials presiding over the next one will react in the same manner as Geithner, Henry Paulson — Geithner’s predecessor as Treasury secretary — and Federal Reserve Chairman Ben Bernanke did in 2008. They will want to stop the panic and save the sermons on moral hazard for later.
This means the important post-crisis work that remains isn’t to fret over too big to fail; it is minimizing the likelihood and severity of a future panic. Rather than banning bailouts, ban the conditions that lead to them.
We know what happened in 2008: Wall Street was struck by a modern-style bank run. Yet most of the regulatory response hasn’t been concerned with deterring another panic. The Dodd-Frank financial-reform law and other measures are mostly about making sure that banks don’t do something stupid, such as operate with too little capital, or trade derivatives without transparency. These are good and worthy goals. But at some point, if history is any guide, banks will discover some new, supposedly foolproof, asset class and become too exposed to it. It won’t be tulips; it won’t be subprime mortgages; it will be something we can’t anticipate now. And when this new “sure thing” starts to look dicey, banks will be vulnerable again.
Although Congress mostly avoided the issue after 2008, we do have experience in deterring panics. Regulations tend to focus on what banks own (assets such as loans and securities). Avoiding panics is concerned with what they owe (liabilities, which include deposits).
After the bank runs of the early 1930s, the United States enacted deposit insurance. And since then, customers haven’t run to the bank, even if the bank is thought to be unsound.
This poses a moral hazard: What if banks, realizing their deposits are insured, recklessly gamble on unsound assets? This happened in the savings-and-loan crisis in the 1980s, and it was expensive.
After that, the price that banks paid for deposit insurance was adjusted according to risk levels. Amazingly, even during the crisis of 2008, the premiums paid by healthy banks were enough to cover depositor losses in failed institutions. Insurance worked.
We did have bank runs in 2008, though not the kind seen in the old photographs with men in hats and coats lined up on the sidewalk. Instead of ordinary depositors, the people who pulled their money out were investors in various unregulated instruments such as repurchase-agreement loans, short-term commercial paper and money-market funds. Each of these is similar, in an economic sense, to a deposit: They offer people and institutions a place to park savings with seeming security and the option of immediate withdrawal.
During the financial crisis, it was these “depositors” who panicked. The refusal by lenders to roll over short-term IOUs led to the failure of Lehman Brothers Holdings Inc. and the near-collapse of many other firms. The difference between old-fashioned deposits and the so-called shadow-market loans described above is that the former can only be issued by banks and in certain well-defined circumstances. And banks must purchase deposit insurance. Shadow deposits are uninsured and mostly unregulated.
The solution, as in the 1930s, is to regulate short-term IOUs and to require, in many cases, insurance. In broad terms, if you are a financial institution, you would be able to borrow short-term funds only under certain conditions and, when you did, you would need insurance. This would have a cost, just as deposit insurance has a cost.
Banks probably would have to shift some of their funding to more stable, long-term credit sources. Their funding wouldn’t be poised on a tripwire, and lenders wouldn’t have cause for panic.
Banks are likely to oppose such measures, which would cut into their profits. Recently, to the satisfaction of bankers, international regulators in Basel, Switzerland have actually loosened liquidity standards aimed at preventing a repeat of 2008.
Morgan Ricks, a former Treasury senior policy adviser and now an assistant professor at Vanderbilt Law School, says the banks’ cheap overnight funding provides undeserved, “subsidy profits." Their borrowing costs, he says, are inordinately cheap because the market believes that banks won’t be allowe to fail. Insurance would put a price on that subsidy.
Ricks says the regulatory response to the crisis “focused on the wrong stuff.” The first priority should be “the instability of the funding model.”
Gary Gorton, a professor of management and finance at Yale University, with co-author Andrew Metrick, wrote his own prescription in “Regulating the Shadow Banking System.” The paper begins with the observation that “After the Great Depression, by some combination of luck and genius, the United States created a bank regulatory system that was followed by a panic-free period of 75 years.” That ended in 2007 “and the ensuing panic was centered in a new ‘shadow’ banking system.”
The paper says money-market mutual funds, for example, offer “an implicit promise” — in effect, free insurance. Its authors advocate regulation that would winnow away this freebie.
Gorton and Ricks have targeted the explicit place where moral hazard induces bad behavior. When Ricks writes about “subsidy profits” and Gorton discusses “implicit promises,” each is talking about the potential for a future bailout to corrupt free-market calculations of risk. If Congress and rule makers want to get serious about too big to fail, this is the place to start.
Lowenstein is the author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.”