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National Review Online

 

Commercial Banks' 'Safety Net'

February 03, 2010

By Nicole Gelinas

In pushing “the Volcker rule,” the Obama administration has made a dismaying decision: to entrench further large commercial banks’ “too big to fail” status in the eyes of the markets.

In Senate testimony yesterday, former Federal Reserve chairman Paul Volcker distilled the rough tradeoff that the administration is presenting to Congress and the public. “I tell you, sure as I am sitting here, that if banking institutions are protected by the taxpayer, and they are giving free reign to speculate . . . my soul is going to come back and haunt you,” Volcker said to senatorial chuckles.

The equation is clear: Banks have a safety net by virtue of their ability to gather FDIC-insured deposits and their right to borrow from the Federal Reserve as a last resort. They should stop playing the markets with this government support, the administration argues. So they should sell off their hedge funds and proprietary-trading desks.

But the Obama administration should not try to make a tradeoff based on a premise that doesn’t exist.

The FDIC is not supposed to represent blanket immunity from market forces for big banks. In fact, it’s supposed to help markets discipline big banks. Protection for small depositors is supposed to allow for bank failure, including uninsured-lender losses, without mass-scale public panic. Likewise, insolvent banks are not supposed to use Fed borrowing privileges to stay in business.

A big reason that we got the financial crisis is that Washington, starting in the Eighties, began to confuse some commercial banks’ limited access to the benefits provided by a public safety net with unlimited access to mass-scale bailouts.

In 1982, for example, when Penn Square failed, it failed. Its uninsured lenders took their losses.

Just two years later, in 1984, the Reagan administration took a different approach. It was afraid that Continental Illinois, a big commercial bank, couldn’t fail, because its reliance on short-term, uninsured funding markets would put the economy at risk of even a fleeting panic in those markets.

So Washington guaranteed all of Continental’s lenders. At the time, Volcker told Congress that the bailout would not set a precedent (it’s in my book!).

But the administration — and successive administrations — never fixed the underlying problems that caused the Continental bailout. For one thing, the financial industry and the nation’s credit supplies were becoming too dependent on short-term markets, which can panic quickly. Banks and other institutions increasingly borrowed overnight from short-term global investors. They also turned 30-year mortgages into tradable securities, and thought for some strange reason that this transformation guaranteed perfect loss-free liquidity (it doesn’t work in the stock market).

So the bailout did become a precedent, because future credit-killing panics were inevitable. This is somewhat important. If you want a financial-debt crisis, you should subsidize financial debt with taxpayer money.

It’s never too late to fix that problem. In fact, uninsured lenders to small banks take their losses. Just look through the FDIC’s list of recent bank failures to see the line of claimants, including uninsured lenders, who must wait to see if a failed bank will have enough funds to cover their claims.

Washington is throwing around the “safety net” for commercial banks far too loosely. Commercial banking institutions are not supposed to be protected by the taxpayer, no matter what tradeoffs they make. The safety net is for the public.

We lost that battle long ago, you say? Well, yes. And look what happened.

Original Source: http://corner.nationalreview.com/post/?q=YWEwYTBjMmE3ZjVlNDc4ODRhYWVjZGI0MzNiNjk4ODY

 

 
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