The Government Needs to Be Able to Bail Out Banks Sometimes

Eric Posner weighs in.
July 28 2014 4:26 PM

We Don’t Need to End “Too Big to Fail”

The government needs to be able to bail out banks sometimes.

President Barack Obama meets with Rep. Barney Frank and Sens. Dick Durbin and Chris Dodd at the White House.
President Obama meets with Rep. Barney Frank and Sens. Dick Durbin and Chris Dodd at the White House prior to a financial regulatory reform announcement on June 17, 2009.

Photo by Pete Souza/Official White House Photo

The Dodd-Frank Act celebrated its fourth birthday last week, but the House GOP did not come to the party. On July 21, the Republican staff of the House Committee on Financial Services issued a report—called “Failing to End ‘Too Big to Fail’ ”—thundering that the act has sowed the seeds for another round of bailouts by encouraging banks to grow too big to fail. The zillion-page statute has spawned 208 regulations, with at least 190 more to come. Not even liberals have shown much enthusiasm for it. Everyone seems to agree that the law has failed to ensure no bailouts will ever take place again and that the blizzard of regulations is questionable.

But the act, while imperfect, was a significant achievement, and the House report’s criticisms are seriously muddled. The report denies that deregulation of the financial industry caused the financial crisis but then blames regulators for weakening rules that limited what risks banks could take. So it both criticizes regulation but argues that regulation was insufficient.

The report’s main complaint is that the Dodd-Frank Act institutionalizes a government commitment to rescue firms hit by financial panic. The report quotes President Obama’s statement that “Because of this law, the American people will never again be asked to foot the bill for Wall Street’s mistakes,” and then complains that Dodd-Frank does nothing of the sort—that it does not stop the government from bailing out firms, and in some ways makes it easier to do.

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But a no-bailouts goal is foolish. The government’s power to make emergency loans during a financial panic is essential. In the best case, the knowledge that the government will intervene can stop panics from starting in the first place. But if not, only government intervention can prevent a financial panic from shutting down the economy. It’s true that the government backstop gives banks perverse incentives to take risks and grow too large. But that’s why those hundreds of rules are necessary.

For all its complexity, Dodd-Frank reflects a commonplace government function: to provide aid to the public in case of emergency. Suppose a bad rainstorm causes a river to overflow its banks and flood a city. Everyone agrees that the government should send in emergency personnel to rescue people and give them shelter until the waters recede. Most people believe that the government should also lend a hand as people rebuild.

Knowing that the government will come to their aid in a flood, people are liable to be overly casual about the risks they face. They might build their houses too near the river and fail to take precautions like evacuating on rainy days. This risky behavior, if left unchecked, raises the costs of rescue and rebuilding should the flood occur. To discourage this risk-taking, the government issues regulations requiring people to build their houses a certain distance from the river, use reinforced walls, and take other precautions.

This familiar logic applies to financial regulation, except that in a financial crisis, there is too little liquidity rather than too much. While people like to blame banks for the financial crisis—and indeed, many banks that did act irresponsibly have been punished by the government—most financial institutions followed the rules. The problem is that the rules were not strict enough to block banks from lending too much

The emergency personnel in a financial panic do not arrive in boats but sit at the Fed’s discount window and dole out loans. Solvent banks suddenly find themselves with too little cash to give to depositors or other short-term lenders who want to withdraw their money or refuse to roll over their loans. Without emergency loans, banks must sell off assets at low fire-sale prices. An otherwise solvent institution goes bankrupt. Temporary loans from the government allow them to hold onto their assets until they can sell them at their true value.

This is exactly what happened during the financial crisis of 2007-08, and it’s why the government actually made billions of dollars in profit on the loans—a fact that is doomed never to penetrate the public consciousness because of the popular hostility to bailouts. The vital role of the government as lender of last resort, however, has been known for at least two centuries. The Fed was given this power in 1913, not 2010. European central banks have possessed it even longer.

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