No. 3 April 2010
Protecting the Economy from Wall Street:
Can the financial industry pay for its own bailout?
Senior Fellow, Manhattan Institute
As part of Washington's plan to fix Wall Street regulations, lawmakers,
supported by President Obama, want financial firms, rather than
taxpayers, to pay for future bailouts of their industry.
Such a suggestion is impractical. In a future crisis, the financial
industry would need more than $20 trillion up front to cover unknowable
losses if it were to avoid turning to government, the current crisis
shows. That's the amount that would keep investors from deserting
the financial system and causing a depression. This price tag is
far beyond what the industry could afford.
"Moves to Tax Banks to Pay For Bailouts Gain Steam"
Wall Street Journal, March 29, 2010
It's become a piece of global conventional wisdom: the financial
industry should fund its own rescues. As the Journal reported
in March, "U.S. and European governments are moving toward
a consensus on taxing large banks to cover the cost of any future
bailouts rather than asking taxpayers to foot the bill, as happened
in past banking crises." In the United
States, the White House and Congress are considering such proposals.
The German government is mulling a similar levy, while in Britain,
both the Labour government and its Tory rivals agree on this principle.
The idea seems a way to temper public anger. As President Obama
said in his State of the Union Address, "
if there's one
thing that has unified Democrats and Republicans, and everybody
in between, it's that we all hated the bank bailout. I hated it.
You hated it. It was about as popular as a root canal." Voters
have consistently voiced outrage over the unfairness of the bailouts
that Washington has effected since the Federal Reserve, offering
nearly $30 billion in loan guarantees, engineered the purchase of
the failing investment firm Bear Stearns by JPMorgan Chase in March
2008. Outrage reached a crescendo six months later with the federal
government's $182 billion rescue of failing insurance giant AIG.
Anger is strong despite the fact that the government had no choice
but to act as it did. If Washington had not enacted programs such
as the Troubled Asset Relief Program (TARP) to pump money into financial
firms and stem losses in the industry, investors would have fled
banks, investment firms, and insurerskilling off credit and
forcing the economy to slash millions more jobs than it has.
The idea of requiring financial firms to pay to protect themselves
also seems rooted in precedent. After all, if the Federal Deposit
Insurance Corp (FDIC) can use the proceeds of a bank fee to guarantee
small deposit accounts against losses in bank failures, the thinking
goes, the government can create a broader fund through which the
financial industry "insures" itself against all financial-industry
President Obama laid the groundwork earlier this year. In January,
he proposed a ten-year, $117 billion "financial
crisis responsibility" assessment on large financial firms
to pay for bailouts that occurred in 2008 or later, calling it a
fee to pay back the taxpayers who rescued them in their time of
need." Looking toward the future,
Treasury Secretary Timothy Geithner said in a March
speech that "reforms would put in practice the principle
that large institutions should bear the costs of any losses to the
Congress has taken the concept further, proposing a permanent fund
for future rescues. The financial-reform bill that Sen. Chris Dodd
(D-Connecticut) proposed in March would require large financial
firms to pay for an "orderly-liquidation fund." The government
could use the fund's resources to help wind down financial firms
it deems unable to go through normal bankruptcy procedures.
The FDIC, which would be in charge of such liquidations, could
tap into the fund to rescue uninsured lenders to the financial industry,
a form of extraordinary support similar to what the U.S. government
has done for the financial industry since 2008 through TARP and
Why industry-funded bailouts can't work
Pre-funded bailouts, though, sound too easy to be trueand
comparison to the FDIC, for one, is inapt. FDIC insurance protects
the economy only against public panics, not against the kind of
massive panic within the financial industry that we saw in
2008. FDIC insurance draws on all banks to protect small depositors,
who are but a small subset of financial-industry lenders. FDIC insurance
does not prevent bank failures; rather, in quelling public fear,
it enables orderly liquidations of failed banks, through which uninsured
lenders do take their losses.
FDIC insurance, then, does not protect against the type
of systemic financial-industry risk that nearly killed Wall Street
in the fall of 2008. That systemic financial-industry risk comes
not from public panics, but from the panicking of sophisticated
investors -itself the result of inadequate limits on debt as well
as inadequate rules for trading financial instruments such as "exotic"
Inadequate regulations can cause investor panics by allowing bubbles
to distort asset prices and credit markets to an irrecoverable extent.
When bubbles burst, they leave behind so much debt that the financial
industry is unable to repay it. Investors know that business failures
are inevitable. But they don't know which financial firms will go
under, so they pull their money from every firm, just in case.
In the current crisis, for example, AIG, putting no consistent
level of cash down, issued tens of billions of dollars' worth of
unregulated credit default swaps to guarantee mortgage securities
against losses. These promises made the debt seem safeincreasing
lending and pushing up asset prices. But when AIG could not make
good on its promises, no one knew who would be left unpaid, and
who, in turn, would be bankrupted by AIG's default.
The financial industry will never have enough money to protect
itself and the economy from such fear. The true tab for such rescues
is not the retroactive cost, as the White House and regulators intimate
when they say they'll make the financial industry pay back net losses
from TARP's financial bailoutsestimated, as Obama notes in
his bank-fee proposal, to be around $100 billion.
the true upfront cost of future financial-industry bailouts is what
investors demand at the time of an acute crisis for refraining from
pulling all their funds from the financial system, as well as the
amount that Washington thinks the financial system needs at that
time to avoid an economic depression. Those costs, in the present
crisis, have exceeded $20 trillion (see graph, attached data).
The figure includes the cost of the measures that the government
has taken to prop up markets directly (TARP injections of capital
into banks) as well as indirectly (Federal Reserve purchases of
securities to keep prices high and avoid financial-industry bankruptcies).
For example, the figure includes the Federal Reserve's purchase
of $1.25 trillion in mortgage-backed securities, which prop up the
prices of similar mortgage securities that financial firms still
hold on their books. It also includes the FDIC's extraordinary guarantee
of up to $940 billion in financial-firm bonds, which allowed the
firms to borrow in the midst of an investor panic and avoid selling
off assets at crisis-level prices. The figure does not include
the economic stimulus or the auto-industry bailouts, even though
these measures, too, likely have averted immediate financial-industry
True, the government and the financial industry decided not to
tap some of these programs in the end and didn't use others to the
maximum extent. But markets didn't know those things when the government
first made its promises to step forward, if necessary.
How much is $20 trillion?
Twenty trillion dollars is far more than the financial industry
could ever pay. It is 39 percent more than the gross domestic product
(GDP) of the United States. It's 24 percent more than America's
financial industry explicitly owed to existing
creditors before the 2008 bailouts began.
Even if the financial industry could make a modest down-payment
on this bailout fundsay, $2 trillionthat amount
would pose a systemic risk to the economy of the type the government
hopes to avoid. The government could not invest $2 trillion in any
financial marketsTreasury bond markets, global stock markets,
real estate, or some combinationwithout distorting them. Moreover,
in a crisis, global investors would expect the bailout fund to dump
some assets to pay for its rescues. This expectation would itself
exacerbate price declines.
Back to the financial-reform drawing board
In the future, as now, the financial industry won't be able to bail
itself out before financial panic results in a depression. The only
protection for the economy is a set of predictable regulationsincluding
consistent borrowing limits and trading rules applied to all financial
firms and instruments.
Such rules would have avoided the disasters that started in 2008.
With consistent cash-down requirements on the promises it made with
credit-default swaps, for example, AIG, it is likely, never would
have made such a large volume of promises; fewer such promises,
in turn, would have tempered the bubble. If the company had failed
anyway, the economy would have had a cash cushion with which to
withstand hefty losses.
For more information on how such rules have worked in the past
and can work again, see After
The Fall: Saving Capitalism From Wall Street and Washington
(Encounter Books, 2009).
- Davis, Bob, "Move to Tax Banks for Bailouts Gains Steam,"
Wall Street Journal, March 29, 2010.
- Calmes, Jackie, "Taxing Banks for the Bailout," The
New York Times, January 14, 2010; State of the Union Address,
January 27, 2010.
- Remarks before the American Enterprise Institute on Financial
Regulatory Reform, March 22, 2010.
- "Restoring American Financial Stability Act of 2010,"
Senate draft, March 15, 2010.
- SIGTARP, Quarterly
Report to Congress, July 21, 2009.
- Flow of Funds report, Federal Reserve, March 11, 2010.