Everyone is pissed off about bailouts. Everyone claims to hate Wall Street banks that avoided the consequences of their bad decisions and got billions of taxpayer dollars while unemployment skyrocketed. But what are we going to do about it? Naturally, have a big partisan fight where Democrats propose ambitious, far-reaching legislation and Republicans endlessly criticize it and propose next to nothing.
But what exactly is the problem that we’re trying to solve?
There is first the basic problem of fairness. The bank executives, traders and investors whose recklessness and short-sightedness were directly responsible for the biggest economic downturn since the Great Depression and massive human misery in the form of prolonged unemployment got huge amounts of money from the government. For the most part, they are still operating profitably. Apart from any strict policy issues, this is an outcome that is so blatantly unfair that it should be avoided as a matter of principle. The related, structural problem is one of “too big to fail.”
But that locution is a bit misleading. Certainly financial institutions can, by virtue of their size, threaten the stability of the economy. But smallness does not guarantee systemic soundness. Lehman Brothers was hardly the biggest financial institution and its failure caused one of the biggest panics in recent memory.
But whatever you call it, we have a problem of there being financial institutions whose failure could bring down the entire economy. They’re operating with an implicit guarantee that the government will bail them out should things get really bad. This current set up allows these banks to take bigger and bigger risks, thus netting bigger and bigger profits, while also upping the probability that they will fail (after all, more risk is more than just the opportunity to make money). They get to keep the upside from the risk while we, the taxpayers, end up covering the downside.
So what to do about it? Well, Senate Republicans, in their role as the opposition party have one big idea: nothing. Or, essentially nothing. To put a more fair spin on it, they simply want to say that bailouts will never happen again. Their other major platform, however, conflicts with this populist conviction: fealty to Wall Street. After all, minority leader Mitch McConnell and Banking Committee ranking member Richard Shelby met with 25 Wall Street executives where they explicitly stated that they wanted Republicans to represent their interests in this legislative fight. And those interests comply with essentially maintaining the status quo — which means the possibility of future bailouts.
If you really wanted to make the Republican principle (no more bailouts) a reality, then you’d have to enact measures that severely restricted the size of banks, what trades they could engage in, how much money they could borrow to finance their trade or what portion of their capital could be potentially lost. And, obviously, banks wouldn’t want those regulations and so we won’t see Republicans proposing them.
That’s why when it comes to something like regulating derivatives — securities that track the change in value of another product, like a futures contract for oil and whose proliferation many think contributed to the economic crisis — we see Democrats proposing tough, restrictive measures and Republicans opposing them And while it’s easy to say that if Goldman Sachs went under tomorrow it wouldn’t get a bailout, could we really say the same thing about some kind of massive financial failure in 15, 20 or even 30 years? Why did the Republican leadership (along with, of course, the Democratic leadership) support the bailouts in the first place?
So what do Democrats want? Chris Dodd, the chairman of the Senate Banking Committee has a bill that does a lot of things, but most importantly, it would create an “Agency for Financial Stability” which would identify which firms are “systemically important” to the economy and single them out for more supervision and regulation so that they are less likely to fail.
One problem with status quo regulations that the Dodd bill would address is the proliferation of institutions that aren’t technically banks but who perform bank like activities but are not regulated like banks. The Financial Stability Oversight Council would oversee those institutions that are systemically important and could adjust capital requirements so as to reduce the riskiness of the institutions.
Another key item of the bill is “resolution authority,” which is a plan for how the government will deal with a systemically important firm failing. This is what the Republicans are talking about when they say that the Democrats’ plan would institutionalize bailouts. In reality, what happens is that the government would raise a fund from banks themselves in order to fund any possible winding down of these institutions — just like how banks pay the FDIC for insurance on their deposits and how the FDIC has a set procedure for taking over failed consumer banks.
The Dodd bill tries to make it so shareholders and management of failed financial institutions don’t gain from the resolution of their companies — which was hardly the case for the recent round of bailouts — but also that the markets don’t freak out when a large institution fails.
It would be nice if we could wave a magic wand and say that no more bailouts will ever happen and then have financial institutions self-regulate. But what we learned from the Great Depression — and relearned recently — is that a financial crisis and a wave of bank failures helps no one in the short or long term. Instead, we need to come up with responsible regulatory solutions to both minimize the possibility of financial crises and to mitigate their impact. And the Dodd bill, which isn’t perfect, comes close to achieving that goal.