happened 1
http://baselinescenario.com/
What to the global economy and what we can do about it
http://baselinescenario.com/2011/03/05/a-healthy-financial-system-cannot-be-built-on-the-expectation-of-bailouts/
downloaded 17 april 11
A Healthy Financial System Cannot Be Built On The
Expectation Of Bailouts
By Simon Johnson. Testimony submitted to the Congressional Oversight Panel, Hearing on the TARPs Impact on
Financial Stability, Friday, March 4, 2011.
I.
Summary
1)
The financial crisis is not over, in the sense that its impact persists and even continues to
spread. Employment remains more than 5 percent below its pre-crisis peak, millions of
homeowners are still underwater on their mortgages, and the negative fiscal consequences at
national, state, and local level remain profound.
2)
To the extent that a full evaluation is possible today, the financial crisis produced a pattern
of rapid economic decline and slow employment recovery quite unlike any post-war recession
it looks much more like a mini-depression of the kind the US economy used to experience in the
19th century. In addition, the fiscal costs of the disaster in our banking system so far amount to
roughly a 40 percentage point increase in net federal government debt held by the private sector,
i.e., roughly a doubling of outstanding debt.
3)
In this context, TARP played a significant role preventing the mini-depression from
becoming a full-blown Great Depression, primarily by providing capital to financial institutions
that were close to insolvency or otherwise under market pressure.
4)
But part of the cost is to distort further incentives at the heart of Wall Street. Neil
Barofsky, the Special Inspector General for the Troubled Assets Relief Program put it well in his
latest quarterly report, which appeared in late January, emphasizing: perhaps TARPs most
significant legacy, the moral hazard and potentially disastrous consequences associated with the
continued existence of financial institutions that are too big to fail.
5)
Adjustments to our regulatory framework, including the Dodd-Frank financial reform
legislation, have not fixed the core problems that brought us to the brink of complete catastrophe
in fall 2008. Powerful people at the heart of our financial system still have the incentive and
ability to take on large amounts of reckless risk through borrowing large amounts relative to
their equity. When things go well, a few CEOs and a small number of others get huge upside.
6)
When things go badly, society, ordinary citizens, and taxpayers get the downside. This is a
classic recipe for financial instability.
7)
Our six largest bank holding companies currently have assets valued at just over 63 percent
of GDP (end of Q4, 2010). This is up from around 55% of GDP before the crisis (e.g., 2006)
and no more than 17% of GDP in 1995.
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8)
With assets ranging from around $800 billion to nearly $2.5 trillion, these bank holding
companies are perceived by the market as too big to fail, meaning that they are implicitly
backed by the full faith and credit of the US government. They can borrow more cheaply than
their competitors and hence become larger.
9)
In public statements, top executives in these very large banks discuss their plans for further
global expansion presumably increasing their assets further while continuing to be highly
leveraged.
10) There is nothing in the Basel III accord on capital requirements that should be considered
encouraging. Independent analysts have established beyond a reasonable doubt that substantially
raising capital requirements would not be costly from a social point of view (e.g., see the work of
Anat Admati of Stanford University and her colleagues).
11) But the financial sectors view has prevailed they argue that raising capital requirements
will slow economic growth. This argument is supported by some misleading so-called
research provided by the Institute for International Finance (a lobby group). The publiclyavailable analytical work of the official sector on this issue (from the Bank for International
Settlements and the New York Fed) is very weak if this is the basis for policymaking decisions,
there is serious trouble ahead.
12) Even more disappointing is the failure of the official sector to engage with its expert critics
on the issue of capital requirements. This certainly conveys the impression that the regulatory
capture of the past 30 years (as documented, for example, in 13 Bankers) continues today and
may even have become more entrenched.
13) There is an insularity and arrogance to policymakers around capital requirements that is
distinctly reminiscent of the Treasury-Fed-Wall Street consensus regarding derivatives in the late
1990s i.e., officials are so convinced by the arguments of big banks that they dismiss out of
hand any attempt to even open a serious debate.
14) Next time, when our largest banks get into trouble, they may be beyond too big to fail. As
seen recently in Ireland, banks that are very big relative to an economy can become too big to
save meaning that while senior creditors may still receive full protection (so far in the Irish
case), the fiscal costs overwhelm the government and push it to the brink of default.
15) The fiscal damage to the United States in that scenario would be immense, including
through the effect of much higher long term real interest rates. It remains to be seen if the dollar
could continue to be the worlds major reserve currency under such circumstances. The loss to
our prestige, national security, and ability to influence the world in any positive way would
presumably be commensurate.
16) In 2007-08, our largest banks with the structures they had lobbied for and built brought
us to the verge of disaster. TARP and other government actions helped avert the worst possible
outcome, but only by providing unlimited and unconditional implicit guarantees to the core of
our financial system. This can only lead to further instability in what the Bank of England refers
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to as a doom loop.
II.
TARP Compared
1)
In the immediate policy response to any major financial crisis involving a generalized
loss of confidence in major lending institutions there are three main goals:
1. To stabilize the core banking system,
2. To prevent the overall level of spending (aggregate demand) from collapsing,
3. To lay the groundwork for a sustainable recovery
2)
IMF programs are routinely designed with these criteria in mind and are evaluated on the
basis of: the depth of the recession and speed of the recovery, relative to the initial shock; the
side-effects of the macroeconomic policy response, including inflation; and whether the
underlying problems that created the vulnerability to panic are addressed over a 12-24 month
horizon.
3)
This same analytical framework can be applied to the United States since the inception of
the Troubled Asset Relief Program (TARP). While there were unique features to the US
experience (as is the case in all countries), the broad pattern of financial and economic collapse,
followed by a struggle to recover, is quite familiar.
4)
The overall US policy response did well in terms of preventing spending from collapsing.
Monetary policy responded quickly and appropriately. After some initial and unfortunate
hesitation on the fiscal front, the stimulus of 2009 helped to keep domestic spending relatively
buoyant, despite the contraction in credit and large increase in unemployment. It was also
consistent with parallel countercyclical fiscal moves in other countries. This was in the face of a
massive global financial shock arguably the largest the world has ever seen and the
consequences, in terms of persistently high unemployment, remain severe. But it could have
been much worse.
5)
There is no question that passing the TARP was the right thing to do. In some countries,
the government has the authority provide to fiscal resources directly to the banking system on a
huge scale, but in the United States this requires congressional approval. In other countries,
foreign loans can be used to bridge any shortfall in domestic financing for the banking system,
but the U.S. is too large to ever contemplate borrowing from the IMF or anyone else.
6)
Best practice, vis--vis saving the banking system in the face of a generalized panic
involves three closely connected pieces (see chapter 2 of 13 Bankers and the references provided
there):
1. Preventing banks from collapsing in an uncontrolled manner. This often involves at least
temporary blanket guarantees for bank liabilities, backed by credible fiscal resources.
The governments balance sheet stands behind the financial system. In the canonical
emerging market crises of the 1990s Korea, Indonesia, and Thailand where the panic
was centered on the private sector and its financing arrangements, this commitment of
government resources was necessary (but not sufficient) to stop the panic and begin a
recovery.
2. Taking over and implementing orderly resolution for banks that are insolvent. In major
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system crises, this typically involves government interventions that include revoking
banking licenses, firing top management, bringing in new teams to handle orderly
unwinding, and importantly downsizing banks and other failing corporate entities that
have become too big to manage. In Korea, nearly half of the top 30 pre-crisis chaebol
were broken up through various versions of an insolvency process (including Daewoo,
one of the biggest groups). In Indonesia, leading banks were stripped from the industrial
groups that owned them and substantially restructured. In Thailand, not only were more
than 50 secondary banks (Finance Houses) closed, but around 1/3 of the leading banks
were also put through a tough clean-up and downsizing process managed by the
government.
3. Addressing immediately underlying weaknesses in corporate governance that created
potential vulnerability to crisis. In Korea, the central issue was the governance of
nonfinancial chaebol and their relationship to the state-owned banks; in Indonesia, it was
the functioning of family-owned groups, which owned banks directly; and in Thailand it
was the close connections between firms, banks, and politicians. Of the three, Korea
made the most progress and was rewarded with the fastest economic recovery.
7)
If any country pursues (a) unlimited government financial support, while not implementing
(b) orderly resolution for troubled large institutions, and refusing to take on (c) serious
governance reform, it would be castigated by the United States and come under pressure from
the IMF. Providing unlimited implicit guarantees does not help underpin financial stability.
8)
At the heart of any banking crisis is a political problem powerful people, and the firms
they control, have gotten out of hand. Unless this is dealt with as part of the stabilization
program, all the government has done is provide an unconditional bailout. That may be
consistent with a short-term recovery, but it creates major problems for the sustainability of the
recovery and for the medium-term. Serious countries do not do this.
9)
As Larry Summers put it, in his 2000 Ely Lecture to the American Economic Association,
[I]t is certain that a healthy financial system cannot be built on the expectation of bailouts
(American Economic Review, vol. 90, no. 2, p.13).
10) Seen in this context, TARP was badly mismanaged. In its initial implementation, the signals
were mixed particularly as the Bush administration sought to provide support to essentially
insolvent banks without taking them over. Standard FDIC-type procedures, which are best
practice internationally, were applied to small- and medium-banks, but studiously avoided for
large banks. As a result, there was a great deal of confusion in financial markets about what
exactly was the Bush/Paulson policy that lay behind various ad hoc deals.
11) The Obama administration, after some initial hesitation, used stress tests to signal
unconditional support for the largest financial institutions. By determining officially that these
firms did not lack capital on a forward looking basis the administration effectively
communicated that it was pursuing a strategy of regulatory forbearance (much as the US did
after the Latin American debt crisis of 1982). The existence of TARP, in that context, made the
approach credible but the availability of unconditional loans from the Federal Reserve remains
the bedrock of the strategy.
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12) The downside scenario in the stress tests was overly optimistic, with regard to credit losses
in real estate (residential and commercial), credit cards, auto loans, and in terms of the assumed
time path for unemployment. As a result, our largest banks remain undercapitalized, given the
likely trajectory of the US and global economy. This is a serious impediment to a sustained
rebound in the real economy already reflected in continued tight credit for small- and mediumsized business.
13) Even more problematic is the underlying incentive to take excessive risk in the financial
sector. With downside limited by government guarantees of various kinds, Andrew Haldane of
the Bank of England bluntly characterizes our repeated boom-bailout-bust cycle as a doom
loop.
14) Exacerbating this issue, TARP funds supported not only troubled banks, but also the
executives who ran those institutions into the ground. The banking system had to be saved, but
specific banks could have wound down and leading bankers could and should have lost their
jobs. Keeping these people and their management systems in place serious trouble for the future.
15) The implementation of TARP exacerbated the perception (and the reality) that some
financial institutions are Too Big to Fail. This lowers their funding costs, probably by around
50 basis points (0.5 percentage points), enabling them to borrow more and to take more risk with
higher leverage.
16) The Obama administration argues that regulatory reforms, including the Dodd-Frank Act
and associated new rules, will rein in the financial sector and make it safer. Unfortunately, this
assessment is not widely shared.
17) There was an opportunity to cap the size of our largest banks and limit their leverage,
relative to the size of the economy. Unfortunately, the Brown-Kaufman to that effect was
defeated on the floor of the Senate, 33-61, primarily because it was opposed by the US Treasury.
(See http://baselinescenario.com/2010/05/26/wall-street-ceos-are-nuts/, which contains this quote
from an interview in New York Magazine: If enacted, Brown-Kaufman would have broken up
the six biggest banks in America, says the senior Treasury official. If wed been for it, it
probably would have happened. But we werent, so it didnt.)
18) Regulation remains weak and many regulators are still captured by the ideology that big
banks are good for the rest of the economy. Capital requirements will increase but are likely to
remain below the level that Lehman had in the days before it failed (11.6 percent tier one
capital). There will be no effective cap on the size of our biggest banks. They have an incentive
to take on a great deal of leverage. This confers private benefits but great social costs lowering
economic growth, increasingly volatility, and making severe crises more likely.
This testimony draws on joint work with Peter Boone, particularly The Next Financial Crisis:
Its Coming and We Just Made It Worse (The New Republic, September 8, 2009), and James
Kwak, including The Quiet Coup (The Atlantic, April, 2009) and 13 Bankers: The Wall Street
Takeover and The Next Financial Meltdown.
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see also clip of Andy Haldane, Bank of England:
http://www.ianfraser.org/andrew-haldane-outlines-proposals-for-breaking-the-doom-loop/