Ryan Streeter: Should governments be giving large financial institutions protection against collapse?

Ryan Streeter is a Senior Fellow at the Legatum Institute in London and can be followed on Twitter here.

Nearly two years after the global financial crisis erupted, the world has still not seen a definitive policy response to the major source of the problem:  the implicit and explicit protections that governments give large financial institutions against collapse.  In the  country where it all began in earnest – the United States – lawmakers are touting “comprehensive” reform of the financial sector.  The Dodd-Frank bill, as it is known, runs well past 2,000 pages and purports to lead the way in fixing the financial sector. Don’t believe the hype. 

The proposed legislation preoccupies itself with the hyper-regulation of entities with far less connection to the crisis than the government-backed mortgage giants, which the proposal doesn’t touch, and with the creation of yet another regulatory agency with responsibility for transactions (such as payday loans) that had nothing to do with the mess we are in. While the proposal does offer some limits on possible bank rescues, it also creates new opportunities for even larger bailouts in the future.

The UK government’s 2010 budget bandies about ideas such as bank levies and bonus limits, which have a certain popular appeal but ultimately step around the core problems.  Let’s hope the recently-formed Vickers Commission will more seriously focus on the ways in which we built a system in which risky behaviour was somehow less risky for bankers than it is for the rest of us ordinary people.

Ryan Streeter is a Senior Fellow at the Legatum Institute in London and can be followed on Twitter here.

A new Legatum Institute report by economist Russ Roberts, entitled Gambling with Other People’s Money, paints a clear picture of the problem lawmakers seem conspiratorially committed to ignore:  the collusion between the financial sector and policymakers to create an environment that lessens the negative effects of financial risk-taking.  Roberts, a well-known free-marketeer, writes:

"...Wall Street was (and remains) a giant government-sanctioned Ponzi scheme. Homebuyers borrowed money from lenders who got their money from Fannie Mae, Freddie Mac, and banks that borrowed money from investors who expected to be reimbursed by the politicians who took that money from taxpayers. Almost everyone made money from this deal except the group left holding the bag—the taxpayers. There is an old saying in poker: if you don’t know who the sucker is at the table, it’s probably you. We are the suckers. And most of us didn’t even know we were sitting at the table."

This is not a populist rant against rich bankers. Rather, Roberts’ roots his view in a survey of a three decades-long history in which US policymakers rescued the creditors of financial institutions that behaved recklessly. Between 1979 and 1989, 1,100 commercial banks failed in the United States, and 99.7 percent of their deposits were reimbursed by policy decisions.  During and after that period, the US government began a deliberate pattern of intervening to save financial institutions. In fact, it didn’t stop at financial institutions – its 1995 rescue of a country, Mexico, was effectively a $50 billion bailout of Mexico’s creditors, many of whom were on Wall Street.

Roberts documents how Washington’s implicit guarantee of large financial institutions created the toxic environment of perverse incentives to pursue increasingly risky bets with other people’s money (the firms were much less risky with their own capital).  And the reckless class on Wall Street proved their gambles were worth the risk when the government intervened to save most of the biggest culprits in the 2008 crisis.

Roberts writes, “[Bank] rescues have distorted the natural feedback loops of capitalism”. This distortion explains such practices as investors putting their money into AAA-rated securities when they knew the issuers of the securities had paid the ratings agencies for the AAA designation. And how else does one explain the one trillion dollars’ worth of high-risk mortgages in 2006 (compared to less than $100 billion in 2000) when all housing analysts could see a growing inventory of unsold homes in America? So long as taxpayer-funded bank rescues remain a future probability, we can expect to see this kind of behaviour again.

The last thing we need right now is for the globally-interconnected financial sector to receive greater rather than less assurance that it will be protected from its future bad bets.  Let’s hope the US eventually gets it right, and let’s hope the UK learns from what the US is currently doing wrong.