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An End to Bailouts

by Mark A. Calabria

Conservatives should seek one; here’s how

Perhaps no issue in financial reform is more important to the public than the need to end bank bailouts, which only shift losses from banks and investors to taxpayers. Just as many on the left mistake the redistribution of wealth for its creation, so Wall Street’s protectors on the left and right alike mistake the redistribution of losses for their avoidance. Most Americans — 71 percent in a Rasmussen poll in May 2012 — think government should let troubled banks fail. Among independents, the percentage is 74. Even 60 percent of Democrats agree.

The Dodd-Frank Act institutes procedures for protecting taxpayers by imposing losses on creditors, but then it enshrines the status quo by allowing regulators to forgo those procedures. Similar procedures were in place for Fannie Mae and Freddie Mac but have never been used. The authors of Dodd-Frank never gave any serious consideration to restraining government’s power to regulate banks. Its solution to the  Federal Reserve policies that helped inflate the housing bubble? Increase the Fed’s power. Even when supporters of regulation were critical of the way it was implemented, such as in the area of consumer protection, their solution wasn’t to restrain regulators but only to rearrange boxes on an organization chart. For all his complaints about the Federal Reserve’s failure to enforce consumer-lending laws adequately, Barney Frank helped ensure that the accountable regulators would stay on the government payroll by being transferred to the newly created Consumer Financial Protection Bureau. Government’s power to bail out banks and rescue their debt holders can be limited only by limiting the access that regulators have to the large amounts of cash they can use for that purpose.

The Treasury Department’s Exchange Stabilization Fund is the most obvious place to start imposing such limits. It was established in 1934 to allow the Treasury to manage the value of the dollar relative to other currencies. Given that the United States no longer manages the value of the dollar but instead allows it to float, the fund today, which has about $100 billion, is obsolete. It was used to back the mutual-fund industry. During the Clinton administration, when Timothy Geithner directed the fund, the Treasury used it to protect Wall Street investments in Mexico. The fund should be eliminated or, at the very least, its use should be restricted.

Any serious restriction on bank bailouts must also address the Federal Reserve. The limits that Dodd-Frank places on the Fed’s rescue authority are largely cosmetic. If the Fed is to retain its role as a lender of last resort, its lending should be limited to the discount window, where it lends only against good collateral. The discount window works on similar terms for all banks. The days of the Fed’s picking winners and losers in our financial system should end. That will happen only with the elimination of the Fed’s “13.3” powers (named after paragraph 13.3 of the Federal Reserve Act), which give the Fed authority to assist non-banks, such as AIG, as well as the ability to lend to specific individuals. The Fed essentially has complete discretion in setting the terms of its 13.3 assistance, allowing it to save some parties while letting others fail. The Fed has never articulated a clear and compelling rationale for its drastically differing approaches to Bear Stearns and Lehman Brothers.

Some might object that without the Fed’s 13.3 powers, numerous Fed emergency-lending programs, such as the Term Securities Lending Facility (which provided funding to investment banks), would have been impossible. To some extent that is the point: to eliminate the Fed’s ability to rescue the asset-backed-securities (ABS) market, a kind of shadow banking system. Much of this market was the result of regulatory arbitrage rather than true risk sharing among financial institutions. For instance, large banks purchased credit-default swaps from AIG to lower the amount of capital that regulators require them to hold. Had the Fed not rescued AIG, banks would have been shown a disincentive to manipulate the requirement as they did.

None of the Fed’s emergency-lending programs can be described as monetary policy. They are inherently fiscal actions, which involve the possibility of direct credit losses to the taxpayer. The Fed’s purchase of over a trillion dollars in mortgage-backed securities is no different in substance from the initial proposals for TARP. The difference was in process: TARP was approved by Congress, whereas no elected official voted for the Fed’s assistance programs. Our Constitution requires, and common sense dictates, that fiscal decisions be made by elected officials, whom we can either reelect or vote out of office. The Fed should not be making the decisions it made under its 13.3 powers. Congress should.

A third reservoir of cash available to bank regulators is the FDIC’s deposit-insurance fund. The legislative origin of “too big to fail” can be found in the Federal Deposit Insurance Act, at section 13G, which allows the FDIC, along with the Fed and the Treasury, to declare individual banks “systemically” important and to provide them special assistance. As long as 13G remains, “too big to fail” remains the law of the land.

In addition to 13G’s codification of too-big-to-fail, it served as the basis for the FDIC’s broad guarantee of bank debt, a process that followed from the FDIC’s reading of 13G but that lacked any real basis in statute. It would be bad enough if the FDIC’s only flaw were its illegal backing of bank debt, but these rescues also reinforced the expectation of future rescues. Insured depositors have no incentive to monitor bank behavior, and this moral hazard was the primary driver behind the savings-and-loan crisis in the 1980s. It was also a contributor to the most recent crisis. By reducing market discipline on institutions such as Citibank, deposit insurance allowed risk to build up to levels that uninsured debt holders would not have tolerated.

To reduce risk to the taxpayer, the amount in insured deposits that a bank can hold should be limited — a solution that has the advantage of easy implementation, in that it is easily measured and monitored and therefore not subject to the subjective wisdom of regulators. The previous limit was 10 percent of the insurance fund, although that could be breached by organic growth (rather than via merger). The limit should be reduced to 5 percent and made a hard cap. Banks would still be free to take uninsured deposits, but the risk to the FDIC would be limited.

The expansion of deposit-insurance coverage in Dodd-Frank should be rolled back. Accounts holding up to $250,000 are insured, but few households have that much in total deposits, much less in a single account. The median American household has about $6,400 in bank deposits. Of the 121 million households in America, only about 10 million have total bank deposits above $100,000. Most of these households are in the top 20 percent of earners, with incomes over twice the median. Their median holding of financial assets alone is around $600,000. A typical family with bank deposits over $100,000 has enough income and wealth to buffer a loss in deposits resulting from a bank failure. Ultimately the FDIC should return to the pre-1980s limit of about $40,000 in total coverage per person. To further reduce taxpayers’ exposure, government backing of bank deposits should be limited, or at least limits should be placed on how much the safety net backs any one bank. This can be accomplished without changing depositor insurance for the vast majority of Americans.

Reforming the financial system to eliminate the need for bank bailouts also requires simplification. A major contributor to the financial crisis of 2008 was Basel, the complex scheme of risk-weighting used to calculate the amount of a bank’s capital. This system allowed highly leveraged banks to present themselves as well capitalized. When a bank is said to hold “risk-weighted capital of 8 percent,” for example, the meaning of that “8 percent” depends on the asset against which the capital is weighed. Home mortgages are given a risk weight of 50 percent, so a risk-weighted 8 percent for mortgages means that the bank’s actual capital cushion is 4 percent (8 times 0.5).

By implicitly setting the cost of holding varying assets, Basel encouraged herd behavior, as many banks loaded up on similar assets. For example, banks under the Basel system were required to hold five times more capital for business loans than for Fannie Mae bonds. This encouraged banks to reduce business lending in favor of holding Fannie Mae debt. When they all sold their Fannie Mae bonds at the same time, the bonds’ prices plummeted and a fire sale ensued. The problem became systemic.

Bank-capital risk-weighting can fail. Its application to Fannie Mae and Greece, for example, led to the conclusion that their debt was essentially riskless. The solution is to replace regulatory discretion with a simple, flat leverage ratio. Require all banks to hold, say, 10 percent equity against their lending, regardless of their asset holdings, and a considerable amount of trouble will be avoided. Under current rules, banks can reduce their capital if they hold mortgages and other assets favored by regulators. A flat ratio across all assets would remove regulators from the position of favoring some types of lending over others, while also eliminating the ability of banks to reduce their capital by loading up on these favored assets.

Many commentators, including the FDIC’s vice chairman, Tom Hoenig, have proposed breaking up the banks, either according to the products they offer (a new Glass-Steagall) or by size, in order to reduce the risk of financial crises. But this proposal would not by itself significantly improve our banking system. Breaking up banks would likely result in a system that was more fragmented and less diversified. Note that companies doing a single line of business, such as Fannie Mae, generally performed worse during the crisis, not better, than did companies that were more diversified. A banking system of small entities is not necessarily a safer one. Over 400 small banks failed this business cycle.

The percentage of small banks that are unprofitable is currently five times that of the largest banks. This reflects the regulatory advantages that large banks enjoy, of course, but also differences in the types of risk different banks take on. Government insurance against risks should be limited to the deposit-insurance fund, but what constitutes risk is an empirical matter, not a mere preference. For legislators or regulators to determine which categories of bank activities are risky and which are not is misguided, and the decision will be driven more by politics than by economics. History does not suggest that a banking system characterized by small undiversified banks is a safe one. Returning to the banking system of the 1920s and ’30s would not be an improvement.

Against the kinds of reform I have endorsed, it could be objected that eliminating government guarantees and rescues would lead to depression and financial panic. But in truth, guarantees and rescues already threaten to produce just those outcomes. For example, the run on mutual funds in 2008, to the extent there was one, was caused by an unlimited extension of deposit insurance under the Transaction Account Guarantee Program. As TAG offered businesses and high-wealth households a federal guarantee, they shifted their money out of mutual funds and into banks. The economy then worsened as the amount of funding available to corporate America decreased: Banks did not lend out the new deposits, and a contracted mutual-fund industry had less demand for commercial debt. As we painfully learned, wrapping a government guarantee around one portion of the financial sector will draw money away from other segments. The aggregate supply of funds is not increased, but simply redistributed.

Another justification for government intervention in the financial sector was the “breaking of the buck” by money-market mutual fund Reserve Primary — that is, the dropping of its net asset value below the par value of $1.00. The potential for widespread losses in other money-market funds raised the specter of bank-style runs among mutual funds. But Reserve Primary was heavily invested in Lehman debt; its losses were the result of a bad bet, not a run on mutual funds of a kind the government should offer protection against. Investors in Reserve Primary have recovered 99 cents for every dollar of investment — hardly a loss justifying a host of government interventions.

Republicans suffer from their image as the party of Wall Street, even though Wall Street’s campaign contributions are close to evenly divided between the GOP and Democrats and even though Wall Street resides deep within the Democratic stronghold of metropolitan New York. By philosophy and temperament, Republicans are actually the party more inclined to oppose Wall Street bailouts. One of the most striking differences between Republicans and Democrats is in their levels of trust in government. Republicans are typically skeptical, Democrats typically supportive, of an expansive government with broad discretionary power. In this, Republicans have a natural advantage with independent voters, who generally oppose bailouts. Independents in the General Social Survey are consistently found, however, to have less confidence in banks than do Republicans or Democrats. To be pro-bailout and pro-bank is a recipe for electoral defeat.

Republicans have historically regarded finance as a countervailing force to the power of the state. Although in principle they hold that government should not rescue failed firms, they have too often made an exception for the banking sector. The Republican-party platform of 1912 read, “Our banking and currency system must be safeguarded from any possibility of domination by sectional, financial, or political interests.” Today our banking system is dominated by sectional, financial, and political interests. For Republicans, sensible financial reform will require a return to principles, not an abandonment of them.

– Mr. Calabria is the director of financial-regulation studies at the Cato Institute. He was previously a senior staffer of the United States Senate Committee on Banking, Housing, and Urban Affairs.

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