The current mess in the U.S. banking industry is both unfair and economically inefficient. But there are no easy ways to clean it up.
The situation reminds me of the old joke about the too-agreeable rabbi. Two members of the rabbi’s congregation have a dispute. In the morning, one comes to the rabbi to lay out his case. At the end, the rabbi says “You’re right.” In the afternoon the other party explains his side. To him, the rabbi also says, “You’re right.” After the man leaves, the rabbi’s wife upbraids him: “What are you saying, they can’t both be right!” The rabbi responds, “You’re right.”
Medium and small banks protest that the ongoing banking sector rescue policies heavily favor the big banks. The government considers their behemoth competitors too big to fail and bends over backward to bail them out. The feds hand over T-bonds in exchange for bad loans. They ignore the questionable nature of large parts of the big banks’ balance sheets. They loan the big banks money at near zero interest rates.
Medium and small banks cannot tap these special bailout funds and have to pay market rates to get loanable funds. If they don’t write their bad assets down to true value, their bank examiners ding them. If their balance sheet gets bad, the FDIC drives into town on Friday afternoon and closes them down.
All the while, the big banks are using their free money and untouchable status to steal smaller banks’ best loan customers. And the FDIC is raising the insurance premiums that even prudently run banks must pay because of unprecedented losses closing out poorly managed competitors.
These complaints are all valid.
But government officials and economists argue that banks generally should be subject to market forces, and should have to pay market rates. If they go broke, they should not be bailed out. The only exception to the rule must be that in exigent circumstances, when a cascading failure of large financial institutions could throw the whole economy into a financial collapse and a depression worse than the 1930s, the Fed should act as a lender of last resort and prop up those banks that are so large their failure would endanger the whole economy. This is not a good policy; it merely is the least horrible alternative in an emergency.
They, too, are right.
But other analysts point out that if government consistently turns a blind eye to big-bank risk-taking on the upside, but just as consistently props them up on the way down, we are going to end up with a banking sector that wastes resources and is economically inefficient. Consumers and the general business sector will pay more for the loans and other banking services they need and taxpayers will periodically have to pony up large amounts. Excessive risk-taking by coddled big institutions will pour society’s scarce capital down rat holes.
Other critics argue a point of fairness. Yes, it may be correct that society as a whole benefits when certain big banks and big firms get rescued while consumers and smaller businesses have to do their own frantic bailing. Yes, these consumers and general businesses would be in even worse shape if, in 2008, the Fed and Treasury had simply stepped back and let the dominos fall.
But, they continue, you cannot blame the average citizen for concluding that this all constitutes a tremendous injustice, as large, wealthy, powerful institutions and individuals get special help while average Joes and Jeans are left to swirl down the tubes. This sense of injustice corrodes the democratic process. It undermines belief in our fundamental economic and political institutions. This well-justified anger makes it difficult to forge sound policies across a broad range of issues, not just those regarding financial markets.
Both these sets of critics are right.
We are in a mess, a big mess. We got into it because we let ideology overwhelm experience and pragmatism. We got into it because, by this time last year, we had let unsustainable trends build to a point where massive bailouts were the least bad alternative. And in the short run, we do need to keep certain big institutions afloat to avoid torpedoing a still frail economy.
Moreover, our least-bad-alternative bailout actions compounded the moral hazard that critics of “too-big-to-fail” asserted for years. After the last 18 months, every financial market participant around the world has ample evidence that the U.S. government will ultimately step in to keep financial behemoths from failing.
Going forward, we need a political consensus that the largest financial institutions need to be reduced in size, including forcible breakups, if necessary. Other solutions, such as requiring firms to hold more capital or to draw up living wills specifying how they will be dismembered in bankruptcy, are useful but insufficient.
We also need more tangible help for smaller banks and businesses and for households. If the big banks continue to borrow essentially interest-free from the Fed, then there needs to be some similar facility for smaller banks.
If big corporations get special treatment in bankruptcy court, then small businesses and households facing foreclosure need more tangible help than they have gotten so far. This may not be a direct economic necessity, but it is a political one.
© 2009 Edward Lotterman
Chanarambie Consulting, Inc.