Too Big to Fail, Once More

Treasury secretary Geithner and Fed chairman Bernanke have unveiled their new plan to give Treasury and the Federal Reserve new powers to regulate troubled non-bank financial institutions that are deemed to be “too big to fail.” Their plan — if approved by Congress — will give the government new powers to seize and re-organize institutions like insurance companies, investment banks, and hedge funds whose collapse might have significant systemic effects.

Messrs. Bernanke and Geithner claim that such powers, had they been available last September, would have allowed financial authorities to undertake a more orderly unwinding of AIG and to avoid in the future such troubles as have arisen recently regarding payment of bonuses to AIG executives and much larger payments from AIG to its various counterparties to cover credit-default swaps which should have never been sold in the first place.

Perhaps this is so. However, on the other side, a few contrary observations:

1. The “too big to fail” doctrine is now being expanded to the point whereby we are no longer sliding down a “slippery slope” toward government management of the financial system — we are plummeting down an ice-covered crevice toward a near inevitable outcome by which credit and investment decisions throughout the economy will be tinged by political influences, primarily by those arising out of the Democratic party. We have already had a small taste of what this will mean via federal intervention in the home-mortgage markets.


2. There was never a strong case for the rescue of AIG last September. It was not likely that the international economy was going to “melt down” if AIG failed. Executives from Goldman Sachs (AIG’s largest “counterparty” bank) have said that their company was never in jeapardy of failing as a consequence of AIG’s insolvency. This was probably true of other counterparty banks as well. AIG’s liabilities, while large, were not large enough to bring down the financial system. AIG, in contrast to Lehman Brothers, was not a bank at all but an insurance company. Bernanke and Paulson were operating in the dark, based on what they were told by bankers who stood most to gain from the rescues.


3. Bernanke and Paulson panicked last September and, in the process, threw the national election to the Democrats and established a terrible precedent in the rescue of AIG that has led to embarrassments and now to ever more ambitious missteps.


4. Why (as Republican appointees) did they do this? It is hard to say. Paulson, as the former chairman of Goldman, was operating within a Wall Street perspective and with massive conflicts of interest. Bernanke was determined to apply lessons he learned from the Great Depression to a situation that was not at all the same. In the 1930s, banks failed as a consequence of the economic slump, the restrictive-money policies of the Fed, and the unwillingness of central bankers to use their authority to provide liquidity to failing banks. In the present crisis, central banks had sufficient authority already to guarantee inter-bank loans and to provide liquidity to the system in the face of AIG’s insolvency. In any case, the great proportion of banks in the country were solvent at the time and have remained so irrespective of the rescues.


5. In addition to extending the bad precedent of AIG, Bernanke and Geithner are putting the cart before the horse, focusing on rescues instead of looking to limited regulatory measures that might prevent such collapses in the first place or at least limit their consequences. Here, once again, they appear to be “going to school” on the depression when FDR responded to the crisis by expanding the control of Treasury and the Fed over the banking system — for example, by providing authority to take over and reorganize failing banks. This was an appropriate and timely measure in the context of the period. It does not follow that an extension of this precedent is appropriate today.


6. It is a mistake to view the bank and AIG rescues as disconnected from new stimulus and budgetary policies. They are in fact intimately connected. Once having rescued Wall Street institutions, Democrats could not say “no” to their various constituency groups when they came calling for their own new funding. It is hardly a coincidence that the stimulus and the original rescue packages were roughly the same size — $800 billion or thereabouts. It is not possible to provide rescues to large Wall Street institutions without at the same time passing out large sums of money to other politically well-positioned groups in the economy. This is exactly what is happening now. Thus bad policy leads to ever-more dubious policies, to the point where any benefit from the rescues are overweighed by the costs of other policies flowing from them.

There should be a broader discussion of the inter-related issues of “systemic risk” and the “too big to fail” doctrine — particularly as they are used to justify such far-reaching interventions by federal authorities.

This piece originally appeared in National Review Online

This piece originally appeared in National Review Online