Congressman Paul Ryan’s selection as Mitt Romney’s running mate is being described as a “game changer” that shifts the presidential election from negative tit-for-tat swipes to a higher strategic plane. What better time than now to have the long overdue discussion about the central issue of the Financial Crisis–what to do about banks and other financial firms considered too-big-to-fail. That discussion need not be rancorous or partisan once all sides recognize that these firms are being bailed out every day.
The Dodd-Frank Act compounds the problem by declaring that every banking organization larger than $50 billion is “systemically important.” This is pure fiction, but it signals that these banks — simply because of their size — are more likely than others to be rescued if they are in danger of failing. The same will apply to nonbanks like insurance companies, finance companies, hedge funds, and money-market funds if they are designated as “systemically important financial institutions” by the Financial Stability Oversight Council.
We’ve seen this movie before, where private companies use public backing to reduce their borrowing costs. It was called “Fannie Mae and Freddie Mac Take the Taxpayers for a Ride.” Then, as now, the subsidy was real and measurable. Lowering their costs of funding and allowing creditors to infer government support made Fannie and Freddie immune to competition and prone to take extraordinary risks.
Today’s systemically important firms reap the same financial benefit of the government’s implicit backing. That benefit is not just some vague, “I’ll-be-here-for-you-tomorrow” feel-good thing. No, it’s a hard-edged financial leg-up that separates winners from losers, acquirers from acquirees, and in the end will determine whether our financial system consists of many large and small firms or only a few behemoths.
Increasingly, policymakers are paying attention to the benefit systemically important banks enjoy and are calling it for what it is — a taxpayer subsidy. To name a few, Federal Reserve Bank of Dallas President Richard Fisher and FDIC director and former Federal Reserve Bank of Kansas City President Thomas Hoenig. Even Fed Chairman Bernanke now uses the “S” word. This, from Bernanke at a recent press conference: “In other words, a bank which is thought to be too big to fail gets an artificial subsidy in the interest rate that it can borrow at ….”
These regulators are talking about banks, but the same benefits will accrue to nonbanks that the FSOC singles out as systemically important. These subsidies are slow-motion bailouts in the present tense.
Regulators, following the dictates of Dodd-Frank, are painted into a corner. Either they go light on the systemically important firms and allow them, by virtue of their size and the taxpayer subsidy, to wipe out all competition; or they bring the regulatory hammer down on them, crippling a large part of the financial system and dashing the hopes for economic recovery.
"Instead of enshrining our TBTF firms, we should be seeking ways to reduce or eliminate their federal subsidies." A way out of this corner is to shift the focus away from past and future bailouts and onto the continuing bailouts. It is the ongoing bailout — the taxpayers’ subsidies of the TBTFs — that is preventing market discipline from playing its customary role of determining winners and losers. The government should not signal to the market that any firm — bank or nonbank — is too-big-to-fail. Instead of enshrining our TBTF firms, we should be seeking ways to reduce or eliminate their federal subsidies.
One way of accomplishing this is to require the TBTFs to identify the portion of their earnings that is attributable to their subsidy. Another approach would be the use of a “bail-in” mechanism forcing creditors to absorb the losses of a failure thus reducing or eliminating the TBTFs’ funding advantage.
Prior to the financial crisis, the policy option of the government intervening to save a systemically important firm was called “constructive ambiguity.” It provided creditors with just enough uncertainty to keep the biggest banks from being subsidized. But the financial crisis and the Dodd-Frank response have turned government intervention into a perceived entitlement. Hyper-regulation and living wills do not change that perception.
To be sure, a new strategy of eliminating the present-tense subsidy will call for bipartisanship, a species that seems on the verge of extinction. But who in either party, whether in Congress or running for president, dares stand up and say, “I support ongoing subsidies for too-big-to-fail financial institutions?” Sure, elections are about differences. But this is one issue that should unite the Obama/Biden and the Romney/Ryan camps.
Wallison, a senior fellow at the American Enterprise Institute, was general counsel of the Treasury and White House counsel in the Reagan administration. Hurley, a law professor and director of the Boston University Center for Finance, Law & Policy, was an Obama Organizing Fellow during the 2008 election.