Treasury’s Explicit Banking Subsidies

March 3, 2009


The government’s plans for bailing out the financial sector are, according to the WSJ, getting "fleshed out", although the ideas in the graphic above are hardly new.

The WSJ story is worth reading in conjuntion with Steve Waldman, who explains that financial institutions are always subsidized by taxpayers in one form or another, and that this kind of explicit subsidy might actually be a better option than the implicit subsidy we’ve had in the recent past:

Banking-as-we-know-it is just a form of publicly subsidized private capital formation. I have no problem with subsidizing private capital formation, even with ceding much of the upside to entrepreneurial investors while taxpayers absorb much of the downside when things go wrong. But once we acknowledge the very large public subsidy in banking, it becomes possible to acknowledge other, perhaps less disaster-prone arrangements by which a nation might encourage private capital formation at lower social and financial cost. Rather than writing free options, what if we defined a category of public/private investment funds that would offer equity financing (common or preferred) to the sort of enterprises that currently depend upon bank loans? Every dollar of private money would be matched by a dollar of public money, doubling the availability of capital to businesses (compared to laissez-faire private investment), and eliminating the misaligned incentives and agency games played between taxpayers and financiers who would, in this arrangement, be pari passu. Also, by reducing firms’ reliance on brittle debt financing, equity-focused investment funds could dramatically enhance systemic stability.

What Waldman is talking about here isn’t exactly the Treasury plan: the main difference is that the financing coming from the Treasury plan is essentially refinancing of old deals, rather than new financing for future projects. But by the fungibility of money, perhaps that comes close.

Waldman’s argument also implies that highly-paid bankers are to a very large degree being paid by governments. They might look like they’re operating wholly within the private sector, but in reality the private sector has what Waldman calls "low frequency, high amplitude breakdowns" in which government has no choice but to step in and pick up the pieces. The WSJ reports that

issuers of asset-backed securities that benefit from Fed financing must be willing to submit themselves to new Treasury Department limits on executive compensation. Some issuers could be reluctant to travel down that road.

The answer to this problem lies with Treasury, and whether it can credibly promise not to bail out financial institutions who don’t sign on to the new scheme. I doubt that it can; right now I think that it’s relying on "moral suasion" (a/k/a arm-twisting) for its plans to bring financial-industry pay levels down to sensible levels. Are bankers’ arms that weak? We’ll see.

Reprinted from

One comment

Comments are closed.