During the recent financial crisis no issue aroused more passion than financial institution bailouts. The standard rationale for the bailouts has been necessity and fear: federal regulatory agencies must have more authority in order to respond to the crisis, or else the public will face terrible consequences. But does this rationale hold up to close inspection?
The nation’s federal financial regulators and the politicians claim to have saved the American economy. In truth they have done everything within their power to expand their own influence—often far out of view from the public and media.
Instead of openly explaining their actions, the bailout agencies have attempted to prevent the public from reviewing their decision-making, often at tremendous cost to taxpayers.
Public Opposed Bailouts
Polls conducted during the peak of the recent financial crisis showed public opinion was overwhelmingly opposed to the bailout of banks and other financial institutions. If bailouts are unpopular with the American public, why did elected officials give financial regulators greater authority to implement them? And how exactly did regulators decide when to bail out a troubled financial institution and when not to do so?
The Treasury Department, Federal Reserve, Federal Deposit Insurance Corp., and other agencies have a habitually dysfunctional modus operandi during a crisis, often characterized by false assumptions and a panic-driven, “not on my watch” approach to policy implementation.
They usually overreact during a financial crisis because they feel they have to ‘do something.’ Most of these actions made matters worse both in the short term, as the panic spread more broadly, and in the long term, as unintended consequences flowed from their initial reaction.
First Bailout Set Pattern
Case in point: the Bear Stearns bailout.
This was the first bailout of the financial crisis of 2008–2009, the original sin, as it has been called. In March 2008, following a sharp drop in its liquidity, Wall Street behemoth Bear Stearns found itself in serious trouble: An unusually large number of customers were withdrawing their funds, and corporate lenders were unwilling to lend it funds necessary to continue its operations. Unless the firm found relief immediately, it would be forced to shut down and many customers and clients would be left in the lurch.
A series of late-night phone calls and emails led to a solution: JPMorgan Chase would provide a short-term loan, but only if the Federal Reserve Bank of New York would lend it funds via the so-called discount window. Worried that the failure of Bear Stearns would take down the banks with which it was doing business, the Federal Reserve Board agreed to the transaction, and JPMorgan Chase was able to save Bear Stearns from immediate collapse.
The seat-of-the-pants effort of the Fed characterized later, panicky regulatory responses to the crisis.
The Fed’s indirect bailout of Bear Stearns illuminates many of the issues surrounding the subprime mortgage loan implosion that began two years earlier, and the events that followed. But a solid understanding of the causes and consequences of bailouts requires answers to fundamental questions:
- What does it mean when a financial institution fails or suffers a run?
- What is the role of a central bank in addressing failures and runs?
- What constitutes a bailout?
Answers to these questions explain the nature of bailouts and the evolution of central-bank lending. They also shed light on the legacies of financial regulations enacted in the twentieth century.
Although the Federal Reserve Act of 1913 was supposed to end financial panics, the average number of bank failures grew by several hundred each year in the decade that led up to the stock market collapse of October 1929. Bank failures became even more common during the Great Depression, peaking at an estimated 4,000 in 1933.
President Hoover created the Reconstruction Finance Corporation (RFC) to reduce the incidence of bank failures and restore depositors’ confidence in the bank system by providing secured loans to unsound banks. Bank failures continued until the agency was given authority to purchase preferred shares of banks and become heavily involved in the management of selected banks. The reduction of bank failures came at the price of reduced market discipline that acts to punish poorly managed banks.
In the early 1950s, Congress phased out the RFC and gave the Federal Deposit Insurance Corporation (FDIC) new powers to assist troubled banks, including the authority to bail out creditors and shareholders of banks in danger of closing, a power not used until 1971. The FDIC faced one of its greatest challenges in 1974 when Franklin National Bank of New York, one of the 20 largest U.S. banks, experienced a massive run and lost nearly 50 percent of its deposits.
The FDIC, the Fe