The hidden costs of bank bailouts

David Shankbone Creative Commons 3.0

AIG Headquarters lobby in New York City on March 18, 2009.

Article Highlights

  • Five years ago, threatened with a collapsing financial system, policy makers took drastic measures to prop up failing financial institutions.

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  • Many economists believe that the benefits of the bailouts outweighed their costs, including the hidden cost arising from moral hazard.

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  • But focusing on that question distracts from the real underlying problem: we have a deeply flawed system in which policy makers and the public are essentially held hostage by financial markets.

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  • That's not free enterprise; that's bullying.

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Five years ago, financial markets erupted in turmoil as numerous large financial institutions faced bankruptcy. Threatened with a collapsing financial system, policy makers took drastic measures, adopting the Troubled Asset Relief Program, as well as other programs intended to prop up failing institutions. These bank bailouts sparked populist outrage across the political spectrum, providing fuel for both the tea party and Occupy Wall Street movements.

Supporters of the bailouts have argued that they were necessary to prevent an even bigger crisis than the one that occurred. And, the government has actually made a profit on its rescue of private financial institutions, selling its equity stake in banks and the insurer AIG for more than it paid. By that logic, the bailouts seem like they were a good deal all around: They restored liquidity to financial markets without imposing costs on taxpayers.

But focusing on whether the bailouts have turned a profit misses the point. The real cost of the bailouts is that they demonstrated the willingness of the government to save large financial institutions that get themselves in trouble. In doing so, they have created a moral hazard problem, giving banks an incentive to be even more reckless in the future.

There's evidence to back up this claim. In a study forthcoming in the Journal of Financial Economics, Ran Duchin and Denis Sosyura, both from the University of Michigan, found that banks began making riskier loans and investments after being approved to receive TARP funds. Viewed by itself, this increase in risk-taking doesn't necessarily reflect moral hazard. But a few additional pieces of evidence suggest that moral hazard played a role in the increased risk-taking.

First, the authors found that it was approval for bailout funds – rather than the actual receipt of funds – that was associated with an increase in risk-taking. In particular, banks that were approved for bailout funds but ultimately did not receive them increased their risk-taking by a similar amount as banks that actually received the funds.

This finding provides evidence for moral hazard because it is mere approval for bailout funds that communicates an implicit government guarantee. While the government may have pressured banks that received assistance to increase their risk-taking in an effort to keep credit flowing, this pressure would not have applied to banks that were approved but did not receive funds.

Second, the authors found that when banks increased their risk-taking, they tended to make the kinds of bets that would go bad precisely in the event of an economy-wide downturn. That's a good investment strategy for banks that expect to receive bailouts in a crisis.

Thus, it appears that the bailouts have reinforced a very disturbing feature of our financial system, namely that large financial institutions can obtain favorable policy by threatening the public with economic collapse. As the special inspector general for TARP argued in a 2011 report, a major cost of the program comes from "the moral hazard and potentially disastrous consequences associated with the continued existence of financial institutions that are ‘too big to fail.'"

Unfortunately, this cost is invisible and unquantifiable. It doesn't show up on the government books. Therefore, it is often ignored in the public debate. And, despite the reforms adopted since the crisis, the existence of "too big to fail" financial institutions is still a significant problem. As Jeremy Stein, a member of the Federal Reserve Board of Governors, argued at an International Monetary Fund conference in April:

"[T]he market still appears to attach some probability to the government bailing out the creditors of a [large financial institution]; this can be seen in the ratings uplift granted to large banks based on the ratings agencies' assessment of the probability of government support. While this uplift seems to have shrunk to some degree since the passage of Dodd-Frank, it is still significant. All else equal, this uplift confers a funding subsidy to the largest financial firms."

Many economists believe that the benefits of the bailouts – limiting the financial meltdown and preventing a much deeper economic downturn – outweighed their costs, including the hidden cost arising from moral hazard. And they might be right. But focusing on that question distracts from the real underlying problem: we have a deeply flawed system in which policy makers and the public are essentially held hostage by financial markets and "too big to fail" institutions. That's not free enterprise; that's bullying.

Sita Nataraj Slavov is a resident scholar at the American Enterprise Institute.

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