Sunday, April 25, 2010

RIP "Too Big to Fail"

I'm not a believer in the concept of government bailouts of private industry.  For one thing, as someone who has been self-employed for nearly 20 years, I have an acute understanding of the risks and rewards of entrepreneurship -- if you want to pursue a business strategy you think could yield greater profits for your wallet, you also take the inherent risk that your strategy might fail and instead leave you broke.  To paraphrase Jimmy Dugan in A League of Their Own, there's no crying in business.  Second, it's been my empirical observation that bailouts of soon-to-be-failed companies tend to benefit the largest equity stakeholders the most -- typically, the institutional investors and the executive team.  So the picture that leaves me is one of the average U.S. taxpayers pitching a few nickels into a hat in order to keep the wealthiest among us from suffering a major hit to their private balance sheets, something that offends my left-leaning sensibilities.

But here is where ideology clashes with reality.  The American experiment with capitalism (some might argue capitalism itself) teaches us that private industry -- left to its own devices -- will tend toward the greatest economies of scale, often found in business strategies that create reduced competition and increased purchasing power.  Thus we consumers of products and services find ourselves invariably at the mercy of a small group of large companies that come to dominate every significant industry in our nation.  The financial services marketplace is no exception to this rule.

In the past few years, every single American adult has had some personal experience with the global financial crisis.  Regardless of one's opinions about the events that served as the spark to the flame, the undisputed accelerant to the crisis was the extraordinary leverage that had been built into a series of arcane financial instruments, then packaged and sold by major financial institutions.  Banks and other investment firms were allowed to widely market these kinds of incredibly risky investment vehicles largely because of an era of deregulation that began in 1999 and because of what now appears to be an arrogance that the institutions themselves believed they were simply too big to fail.  On that last part, it turns out they were right -- the federal government sprung into action in 2008 and 2009, saving some institutions from collapse and providing life support to others that were in danger.  And for anyone who is under the impression that the lessons of the crisis have caused a rethinking of these kinds of bailouts, consider the fact that the failure to save Lehamn Brothers from collapse is now regarded as a seminal error by the Bush Administration.

Against this recent backdrop, there were two significant political developments on the global stage this past week that give me reason to be optimistic we're moving toward a new global regulatory regime in which it's no longer cool to be too big to fail in the financial services marketplace.  The most highly publicized item, of course, was President Obama's speech in Lower Manhattan, in which he called on the titans of Wall Street to join him in his efforts to drive financial regulatory reforms through the Congress.  These reforms, which have passed the House and are currently being debated in the Senate, would seek to put an end to "too big to fail" with a two-part plan:

(1) Charge banks a fee related to the costs of the government bailout of the financial industry; and
(2) Establish the Volcker Rule (named after the former Fed chairman), once again prohibiting commercial banks from engaging in trading purely for their own account and from owning hedge funds and private equity firms.

As with any legislative proposal, there is widespread disagreement about this specific plan, let alone the concept of government intervention into the way that Wall Street conducts its business.  But there is surprising consensus among supporters and opponents, businesspeople and academics, conservatives and liberals, that the plan would be a step in the direction of making sure the federal government has real authority to help end the "too big to fail" phenomenon once and for all.

This is because the heart of the proposed new approach to regulation of the financial sector is the prescription for an "orderly liquidation" of banks or other financial institutions that trigger certain alarm bells as potentially being one we would regard as too big to fail.  The way the approach would work is that, once a bank is judged to be failing, the FDIC would submit a plan for the bank's liquidation -- which includes firing management, wiping out shareholders, handing losses to creditors, and selling off the firm -- and get it approved by the Treasury Department. The FDIC would then seize the bank's assets and oversee an orderly, deliberate, rational winding down of that institution, using funds from the new bank levies to keep the lights on while all this happens. In spite of the absurd accusations from Senate Republicans, this orderly liquidation mechanism would prevent taxpayers from having to foot the bill for the chaos that ensues when large financial institutions are on the brink of collapse.  In essence, insurance premiums collected from the banks themselves would be used to pay the costs associated with winding them down before they hit a crisis point that would require a government (i.e., taxpayer) bailout.

The second major development on this front in the past week was overshadowed in the U.S. by the predictable "Obama takes money from Wall Street and now goes after Wall Street" line of media coverage of the President's speech.  It was a stunning proposal from the International Monetary Fund to impose a two-track series of levies on the world's biggest banks:
(1) A financial stability contribution (FSC) to be paid by all global financial institutions, not just banks, and used to bail out weak and failing firms; and
(2) A financial activities tax (you guessed it, the acronym is FAT) to be imposed on the profits of, and executive compensation paid by, large international banks.
Setting aside the obvious challenges that both the Obama proposal (now a charge being led by Sen. Christopher Dodd in Washington) and the IMF proposal (being championed by Prime Minister Gordon Brown of Great Britain) must overcome before either one of them can become law, there is a perceptible groundswell of international political support for imposing serious new regulations on the large financial institutions that were at the center of the global financial crisis of 2007-2009.  It's unclear precisely how this new regulatory regime will look, but it seems certain that there is little appetite among elected officials or Western taxpayers for future government bailouts of the financial sector.
How did we get to this point, where big banks, enormous investment banking firms and outrageously profitable hedge funds were no longer viewed as engines of wealth creation, but instead the target of so much public anger and political mobilization?  In my view, it's actually pretty simple -- most of us bought the lie that those runaway profits were for the good of the economy.  They weren't.  The capital they allocated wasn't used to spur job creation and economic sustainability, it was used to fuel a frightening housing bubble.  The risk they assumed wasn't spread out among multiple players, it was concentrated into the hands of a few.
The price we all paid for this unregulated freight train was the eventual housing meltdown, freezing of the credit markets, corresponding collapse of the global financial markets, and ultimately the worst economic slump since the Great Depression.  The big banks and other financial institutions took huge, risky bets with other people's money -- and then cried for lifelines from Uncle Sam when the party was over and the bets were called.  How ironic, and yet so predictable, that the same industry executives who called for "laissez faire" oversight of their business affairs and reduced federal intervention into the economy were the ones who stood in the federal bailout line with their hats in their hands when they were in their darkest hours.
Reasonable people can disagree about the time-honored debate of free markets vs. government-regulated markets, but here is what we all know by now: if these giant ships of finance begin to sink, they drag the rest of us down with them, so we're going to end up grabbing the buckets ourselves and bailing them out.  If We The People are going to be on the dime for the failures of global financial institutions, then it seems only appropriate that We The People get to decide when big enough is big enough.
Too big to fail, good riddance.

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