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“Too Big to Fail” Assures Bigness – and Failure

Reader Bobsv57 asks:

"Tom, a question for you. I am under the impression that most, if not all, of the money used to bail out banks has been paid back with interest and it is actually the money used to bail out GM that hasn't been returned. Am I correct in this observation? and if I am, then why to you make the statement calling for no more bank bailouts? (Not that I particularly support them in any case) It would seem that the bail out was a money maker for the Fed, wasn't the interest they charged the banks for TARP funds greater than the interest the Fed pays on it's national debt?"

Bob is right that the banks paid back their loans with interest. But the eventual cost of the bailout is likely to be the failure of our banking system and massively increased public debt. Meanwhile, middle America is starved for credit while the "too big to fail" banks are getting bigger at the expense of their better managed smaller and safer brethren.

An article in the Wall Street Journal explains one way that corporations are positioning themselves for the next credit crisis:

"One strategy treasurers use is to let the government, in essence, pick your counterparties. Stock-photo company Getty Images limits its foreign-exchange business to banks that would be likely to get a bailout if trouble hit.

"'The banks on our list, every single one of them is too big to fail; that's been pretty well advertised,' said Treasurer Tim Murphy…"

How does a bank win business post-bailouts? By being too big to fail! It's hard to think of worse public policy. This guarantees that the "too big" banks will get bigger. Since the giant banks compete with each other and since their huge executive compensation is still based on short term results, these banks have an incentive to take excessive risk. Why shouldn't they. Heads, they win; tails they get bailed out as this quote from a French regulator in the New York Times makes frighteningly clear:

"Yet the French government recognizes that the risk of contagion 'is always there,' and is ready to backstop any of its large banks in the event that conditions deteriorate, said a French regulator who is directly involved in monitoring the national banking system.

"'The French government would never let any major banks fail, so of course we have money available to backstop them', the regulator said."

"Would never let any major banks fail"? Can you imagine a better prescription for irresponsibility? Don't be under any illusion that regulation will stop recklessness given the promise of bailouts. The New York Fed didn't notice the incipient instability of the money center banks before suddenly realizing the need to bail them out. The US government didn't even notice that its creations Fannie Mae and Freddie Mac were disasters on the way to happening; they are now fully government wards. MFS Global still hasn't accounted for $600 million of customer money that turned up missing; in months past its politically well-connected now-ex-CEO, Jon Corzine, convinced nervous regulators not to take any action.

Iceland promised to protect its banks; the country itself then had to be bailed out. Ditto Ireland which didn't run big deficits and had a healthy real economy – until the government decided to back its banks with the country's credit. The French government used to be able to sell bonds with interest rates almost as low as German bonds; now there is the highest spread between interest rates on French and German government bonds since the establishment of the Eurozone. Traders are not at all sure France can afford to bailout its banks – and they know there is no one to bailout France.

So back in the USA our previous bailout of banks has created an expectation that we'll do the same thing again whenever needed and has encouraged customers to make the biggest banks even bigger and more dangerous to the economy. Risky behavior and ludicrous executive compensation are still the rule. Attempts at regulation, like the appropriately named Dodd-Frank Bill, the law the foxes wrote to govern the hen houses, have become captive to the putative regulated institutions; the regulations are more of a burden to the smaller banks which don't pose systemic risk. The big US banks are already beginning to say they may need help with their exposure to their European counterparts. Treasury Secretary Tim "TARP" Geithner anxiously shuttles back and forth to Europe trying to get the Europeans deeper into the morass of bailing out their banks (and ours). He cites his "successful" effort to "save" our banks.

Yes, we got the bailout dollars back for the moment at a low interest rate; think what the banks would've charged for such risky loans if they made them instead of received them! But they are sure to be demanded again. The price of the last bailout was a dysfunctional banking system which is steadily growing riskier.

We must reverse the expectation that irresponsible behavior will be rewarded. We must make it possible for responsible smaller banks to compete, banks which can be allowed to fail if they screw up. Some Presidential candidate should promise to break up all "too big to fail" banks within his/her first year in office. If a big bank fails before we can afford to let it go, it should be dismembered and distributed to its smaller, safer rivals – not merged with another giant as we did during TARP. Being hostage to the investment banks, who've effectively occupied Congress, is not an acceptable status quo.

Related posts:

Preparing for the Next Banking Crisis

When Regulation Is Justified

The Occupiers and Tea Partiers Are Both Right

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