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America has left the door wide open for bailouts

The Fed still has massive power to bail out banks and non-banks. REUTERS/Herb Swanson
The Fed still has massive power to bail out banks and non-banks. REUTERS/Herb Swanson

Last month, an inter-agency regulatory group known as the Financial Stability Oversight Council (FSOC) decided that there are no longer any large financial institutions outside the regulated banking system that pose a threat to financial stability.

Apparently, taxpayers needn’t worry about having to bail out another non-bank during future periods of economic stress as we did with AIG and Bear Stearns in 2008. Under Title I of the 2010 Dodd-Frank financial reform law, FSOC had tagged four large non-banks for heightened Fed supervision to protect against the recurrence of another 2008 bailout scenario.

But with last week’s de-designation of Prudential, the seventh largest financial conglomerate in the country, FSOC has removed all from the regulatory shackles of Title 1.

Chipping away at post-crisis measures to protect taxpayers

Interestingly, while the FSOC has eviscerated Title I designations, which were designed to prevent bailouts, it has left intact another group of systemic designations that facilitate bailouts. These systemic designations are known as Financial Market Utilities or FMUs and they consist of clearinghouses like the Chicago Mercantile Exchange or the Depository Trust, which process securities and derivatives trades for the nation’s big financial firms. Unlike Title I designations, clearinghouses designated as FMUs need not suffer the burdens of bank-like supervision by the Fed. But they do qualify for access to the Fed’s lending facilities if they get into trouble.

Indeed, while Dodd-Frank generally bans bailouts for individual institutions, it exempts FMUs from this ban. Since clearinghouses functioned relatively well and did not need bailouts during the crisis, this extension of the Fed’s bailout authority is more a tribute to industry lobbying than demonstrated need. Not surprisingly, none of the eight clearinghouses found systemic have asked to be de-designated as FMUs. And FSOC seems content to leave them with their special bailout status.

Whatever the particular merits of de-designating Prudential, FSOC’s actions reflect the continuing trend in Washington to chip away at post-crisis measures designed to protect taxpayers. No one now seems interested in preventing another crisis by preparing the financial system for the next downturn which, if the stock market is any guide, could be just around the corner. It seems the emphasis is to unshackle the financial sector, let the good times roll, and if big financial institutions get in trouble, we’ll just bail ‘em out again. Surprisingly, a recent New York Times editorial by former Treasury Secretaries Hank Paulson and Tim Geithner and former Fed Chairman Ben Bernanke — three people who should know better — extolled the bailout tools we used in 2008 and advocated for a full return of those authorities, particularly for the Fed.

As if the Fed didn’t have enough power already. In addition to its new authority to bail out clearinghouses, Dodd-Frank largely left intact the Fed’s ability to provide massive support to both banks and non-banks in time of stress, the latter under a Depression-era provision known as 13(3). Prior to 2008, the Fed avoided 13(3) like the plague fearing the moral hazard created by giving commercial firms and other non-banks access to its money-printing treasures. Alan Greenspan refused to use it even after the 9/11 terrorist attacks. But the 13(3) spigot was opened wide in 2008 and 2009, with the Fed processing $500 billion to $1.6 trillion a week for nearly a year.

Dodd-Frank largely preserved the Fed’s authority to use 13(3) to provide such massive support. The only new limitation is that such assistance have “broad-based availability.” Congress wanted to avoid bailouts of institutions in trouble, not because of systemwide turmoil, but because of their own mismanagement. Dodd-Frank requires that these institutions be placed in either traditional bankruptcy or what is known as a Title II resolution, essentially a bankruptcy process run by the FDIC. Under Title II, shareholders and creditors take losses associated with the failure and board members and executives lose their jobs and three years of compensation. At the same time, the FDIC can provide bridge funding to continue services to the public while the institution is wound down, similar to bankruptcy’s debtor-in-possession financing. The point of Title II is to avoid disruption of services for the failed institution’s customers, while imposing accountability on its investors and managers — accountability that was very much lacking in 2008.

Bailouts as ‘firefighting tools’

No one questions that the government needs tools to deal with financial turmoil. The question is whether we prioritize system resiliency to reduce the risk of another meltdown. And if intervention is still needed, whom do we want to bail out?

Advocates of the 2008 bailouts like to talk about them as firefighting tools. But to continue the metaphor, suppose the fire is at an unsafe tenement, rickety and poorly maintained. Should our “tools” be designed to prop up that tenement and bail out its slumlord? Or should our tools be designed to evacuate the tenement and make sure its residents can relocate to safer, better managed buildings, while putting the slumlords out of business? Title II is designed to accomplish the latter, unlike the bank-centric approaches we used in 2008.

Be it slumlords or financial institutions, if we keep bailing them out, we will get more of them, and eventually crowd out the more responsible actors. We will end up with a system dominated by government-enabled rent-seekers largely insulated from the “creative destruction” that has made our economy great. Our economy will suffer if we give up on preventing crises and accept a new paradigm of serial bailouts. So will our democracy. Public distrust of our institutions was deeply undermined by the 2008 financial debacle when decision-making by our national leaders — politicians, regulators, government institutions, and bank executives — systematically and disastrously let them down. The bailouts that followed only further undermined that trust. Bank executives may have been paying themselves bonuses by the end of 2009, but for most of America, it’s taken eight to 10 years to recover.

Our government owes the public a safe and resilient financial system, one that will support the real economy and continue functioning through economic cycles. De-regulators who are relying on bailouts to deal with the risks of another financial crisis do so at their peril. I doubt our political system can survive the public outrage and cynicism that will surely follow a repeat of the 2008 playbook. Instead of banking on bailouts, we should be doing everything we can to prevent another crisis from happening.

Sheila Bair is the former Chair of the FDIC and has held senior appointments in both Republican and Democrat Administrations. She currently serves as a board member or advisor to a several companies and is a founding board member of the Volcker Alliance, a nonprofit established to rebuild trust in government.

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