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High Taxes = Weaker Growth
A short, lucid and graphic explanation of how high taxes hamper economic grow...
A financial-institution bailout involves govern-ment intervention through a transaction or for-bearance targeted to a financial institution orgroup of financial institutions. The action is pre-emptive as the financial institution does not failand go out of business, but remains a going con-cern, benefiting creditors, shareholders, or counter-parties. In the absence of a bailout, the financialinstitution would either be forced to go throughreceivership or bankruptcy in the prescribed legalform, or have its role in financial intermediationdisrupted.Financial-institution bailout policy in theUnited States is implemented through three agen-cies: the Federal Deposit Insurance Corporation,the Federal Reserve, and the Treasury Department.The need for orderly financial dealings, particular-ly in times of crisis, would dictate a consistentapproach by these agencies based on cumulativeexperience, ensuring that officials devote publicresources only where there is a well-defined, trans-parent, and verifiable policy justification for a bailout. Yet the bailouts over the past year do notreflect a well-defined, transparent, and verifiablepolicy justification. Even in the cases where a stan-dard has been articulated, the agencies have notdemonstrated that they can successfully imple-ment that standard in practice.Beyond the inconsistencies and implementa-tion problems, financial-institution bailout policy has been unwieldy, inequitable, extremely costly,disruptive, and lacking in transparency and over-sight. The policy response of bailouts and mainte-nance of the status quo has been precisely thewrong response, as it has led to retaining many of the mega-financial institutions that pose systemicrisk, thus planting the seeds for future crises.This present crisis has demonstrated that under-taking bailouts of troubled institutions, whichinvolves structuring transactions that attempt totransform the institution into a viable one, whilesimultaneously projecting the reaction of investorsand markets, is a process for which government is ill-suited. These bailout powers should be revoked.Financial angst still hangs over the system as theunderlying imbalances that led to the crisis have notbeen reconciled. The ultimate answer is to placetroubled institutions into receivership or the rele- vant form of bankruptcy—including many of theinstitutions that have already been bailed out.
Bright Lines and Bailouts
To Bail or Not To Bail, That Is the Question
by Vern McKinley and Gary Gegenheimer
_____________________________________________________________________________________________________
Vern McKinley worked at the Federal Deposit Insurance Corporation in the 1980s during the banking crisis inTexas and at the Resolution Trust Corporation in the 1990s as it resolved hundreds of insolvent savings and loans. He currently advises central banks and deposit insurers worldwide on legal and policy issues. Gary Gegenheimer was an attorney with the Office of Thrift Supervision and its predecessor agency, the Federal Home Loan Bank Board, during the savings and loan crisis of the 1980s and early 1990s. Currently he is a senior legal adviser with BearingPoint, Inc., in McLean, Virginia, and has provided legal assistance to central banks and bank supervisoryauthorities in emerging market countries since 1995. The views expressed are solely those of the authors.
Executive Summary
No. 637April 21, 2009
ADVANCE COPY
Introduction
Is there any reason why the Americanpeople should be taxed to guaranteethe debts of banks, any more than they should be taxed to guarantee the debtsof other institutions, including themerchants, the industries, and themills of the country?
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You can’t legislate recovery.
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There has been a long history of financial-institution bailouts in the United States dat-ing back to the first treasury secretary, Alexander Hamilton.
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The most recent inter- ventions have added to the many approachesthat have been used to address financial-sectorstress. Policymakers have held out a rule thatpoorly managed institutions that are threat-ened with extinction should exit the financialsystem. Yet they have always created ad hocexceptions to this rule as well. The need fororderly financial dealings, particularly in timesof crisis, would dictate a consistent approachbased on cumulative experience, ensuring thatofficials devote public resources only wherethere is a well-defined, transparent, and verifi-able policy justification for a bailout. Yet today’s bailouts do not reflect a well-defined, transparent, and verifiable policy justi-fication. As we set forth in the examplesthroughout this analysis, the chairman of theBoard of Governors of the Federal Reserve, thesecretary of the treasury, the chairman of theFederal Deposit Insurance Corporation, andtheir supporting officials have not articulated a clear, bright-line rule to determine whether tobail out a given financial institution. This isnot to say that such a bright-line rule could notbe found through an examination of the recentbailouts, but merely that leadership of theseagencies has not yet publicly provided one.Further, the standard for intervention shouldnot simply be that the failure of an institutionwill impose losses on a broad array of creditors,shareholders, and counterparties, or that it willpresent a challenging or difficult receivershipor bankruptcy process to work through. Evenif a standard can be articulated, it is anothermatter to successfully implement that stan-dard in practice. We believe that the lack of a clear standard and the shifting efforts at imple-mentation have exacerbated the current finan-cial turmoil by sending confusing and incon-sistent signals to market participants.The question for analysis is whether it isappropriate to bail out financial institutions,and if so whether a bright-line rule can bedeveloped and implemented that outlines thecircumstances in which a bailout is appropri-ate. As part of our analysis of bailouts of finan-cial institutions, we will first need to definewhat is meant by the term “bailout” and thenfit the most recent string of interventions intothe historical context. Once we review the his-torical examples, we will determine if the useof bailouts has been consistent over time andif the lessons of earlier periods were recognizedand incorporated into the current approachesor ignored. Then we will turn to developing anappropriate standard. Through our observa-tions and analysis, we hope to provide guid-ance as financial turmoil continues under theObama administration and as these issues arerevisited in contemplated legal reforms for theU.S. financial sector.
Definition of Bailout
For purposes of this analysis, we define a bailout of a financial institution as possess-ing the following elements:
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Government intervention through lend-ing, equity injection, purchase of assets,assisted takeover, loan guarantee, or oth-er tangible benefit, or inaction throughregulatory forbearance for a financialinstitution or group of financial institu-tions. In the case of a transaction, therepayment of funds extended must be atrisk, either because it is not fully collat-eralized or otherwise fully protected.
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The action taken is preemptive, in that thefinancial institution benefiting from
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Today’s bailoutsdo not reflecta well-defined,transparent, and verifiable policy justification.
intervention does not fail and go out of business through revocation of an operat-ing charter and placement into FDIC re-ceivership (commercial banks) or bank-ruptcy (noncommercial banks), but re-mains a going concern, thus benefitingcreditors, shareholders, or counterpartiesof the financial institution.
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In the absence of a bailout, the financialinstitution would either be forced to gothrough receivership or bankruptcy inthe prescribed legal form, or have its rolein financial intermediation disrupted.Based on this definition, recent examples of financial-institution bailouts would include theFederal Deposit Insurance Corporation’s bail-out of Continental Illinois in 1984 and Citi-group in 2008; the Federal Reserve’s bailout of Bear Stearns and American International Group;and the Treasury’s Troubled Asset Relief Pro-gram and bailouts of Fannie Mae and FreddieMac. Under this definition, transactions thatwould not be considered bailouts would be theFDIC’s purchase-and-assumption or payoff transactions, in which a troubled institutiondoes not remain a going concern. Additionally,the exercise of the Federal Reserve’s lender-of-last-resort powers would not be considered a bailout as these loans are traditionally fully col-lateralized.
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Interestingly enough, the so-called“savings and loan bailout” of the 1980s and1990s, which involved the creation of theResolution Trust Corporation, would not be a financial-institution bailout under this defini-tion, as the transactions were structured to elim-inate the institutions as going concerns.
Historical Analysisof Structure of Bailouts,Great Depression to 2007
A historical review of the major financialcrises during the past 80 years is vital to anunderstanding of how the system is current-ly structured, as the influence of these crisesmolded the mandated responses to the chal-lenges of contagion, access to credit, resolu-tion of troubled institutions, and financialinstability.
Depression-era Banking Crisis
The Depression and the changes thatflowed from it brought us our modern bankingsystem. The number of banks in the UnitedStates grew rapidly from 1887 to 1921, increas-ing from about 5,000 to 30,000—an environ-ment most observers of the sector would de-scribe as overbanked.
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Throughout the 1920s,the number of failures began to rise. By 1930,what followed was a series of crises involvingbank failures that brought the number of banks rapidly down to 15,000 by 1934. No lessa pair of observers than Nobel-prize-winnerMilton Friedman and Anna Jacobson Schwartzof the National Bureau of Economic Researchdescribed the first crisis in 1930 as:[a] contagion of fear spread amongdepositors, starting from the agricultur-al areas, which had experienced theheaviest impact of bank failures in thetwenties. But such contagion knows nogeographical limits. The failure of 256banks with $180 million of deposits inNovember 1930 was followed by thefailure of 352 with over $370 million of deposits in December, . . . the most dra-matic being the failure on December 11of the Bank of United States with over$200 million of deposits. That failurewas of especial importance. The Bank of United States was the largest commer-cial bank, as measured by volume of deposits, ever to have failed to that timein U.S. history.
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The term “contagion” refers to a state inthe financial industry whereby a seemingly irrational negative cascading effect causesfinancial institution failures regardless of theinstitution’s actual condition. As SenatorCarter Glass explained during the delibera-tions on deposit insurance in 1933, “whenweak banks begin to topple there takes place a disastrous psychology in the whole country that precipitates runs on strong banks that
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The term“contagion”refers to a statein the financialindustry whereby a seemingly irrationalnegativecascading effectcauses financialinstitutionfailuresregardless of theinstitution’sactual condition.
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Bailouts
A solid analysis of U.S. bailouts from the Cato Institute.
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