Ending the era of bank bailouts

July 9, 2010

The following is a guest post by Cornelius Hurley, director of the Morin Center for Banking and Financial Law at Boston University School of Law, and a former assistant general counsel to the Federal Reserve Board of Governors. The opinions expressed are his own.

As Scott Brown and Barney Frank hash out the difference between a tax and an insurance premium, it’s important to return to the very basics of banking. Banks are in the business of buying and selling money.

They buy money as deposits and other borrowings. They sell it as loans and investments. If someone with deep pockets is foolish enough to guarantee a bank’s deposits and borrowings, that bank can buy money more cheaply. Further, if that person gives his guarantee for free, the bank would have a competitive advantage.

If I told you that an elite class of banks has found such a fool to guarantee their debts, you’d probably want to know who it is. Well, it’s you and me, the taxpayers.

Then you’d want to identify the elite banks so that we could cut off the guarantee, or at least begin charging them for what we’re giving away. Does “too big to fail” ring a bell?

We have to come to grips with the fact that TBTF banks are taking us to the cleaners. Ridiculously, we continue to subsidize them. But there is a clear solution to this problem:

First: identify all the TBTFs. They are: Bank of America, Citigroup, JPMorgan Chase, Goldman Sachs, Morgan Stanley, and Wells Fargo. Lest you think the list is arbitrary, be aware that the vaunted credit rating agencies (Moody’s and S&P) have already rated these firms according to the likelihood of their receiving “support,” i.e., a taxpayer subsidy.

Second: calculate the amount of the subsidy received annually by each firm. Again, this is a straight-forward mathematical exercise, called “notches,” the credit rating agencies award to them. The amount dwarfs any of the levies discussed thus far.

Third: require each bank to create a line item on its balance sheet called the “subsidy-reserve” into which goes the annual amount of subsidy it receives from taxpayers. This “subsidy reserve” will be available in the case of bankruptcy but it will not count as capital for regulatory purposes.

Fourth: require that the only way the reserve can be returned to shareholders is in connection with a divestiture or a spin-off of a line of business by the TBTF bank. Otherwise, it accumulates over time.

Given the magnitude of our TBTF subsidy, the reserve on the balance sheets of the banking behemoths would become very large very quickly. So what would be the result? For one thing, an ominous TBTF bank would become highly capitalized. If sufficient years of accumulation pass, it would become “too safe to fail.”

My guess is that it will not take many cycles before enlightened executives and directors at the TBTFs recognize that they and their companies are better served by downsizing from asset sizes in the trillions to asset sizes on the order of $100 billion.

One thing is certain: this approach would bring to a close the era of profligate bank bailouts, something that the Dodd-Frank bill doesn’t do.


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There is a brilliant simplicity to this idea which ensures that it won’t be taken up by anyone.

It’s one of many fiscal and economic reforms Western capitalism needs…but those who are bombproof lack the motivation to do anything….

http://nbyslog.blogspot.com/2010/07/econ omy-last-thing-america-needs-right.html

Posted by nbywardslog | Report as abusive

I don’t think it can ever be that simple. The systems in place are always complicated (and possibly chaotic) so that it cannot be broken down into simple components. It’s a game of ‘who’s who’ – those on the ‘inside’ don’t want to let in those on the ‘outside’. You bring up an excellent idea, but I feel it is something that will never come to fruition.

Posted by TimelessWealth | Report as abusive

Most everyone in this Country would welcome any way possible to recoup what we’ve “subsidized” these extortionists over the past 3 years. Your way sounds as good as any. The problem we are having is convincing our US Senators we expect them to pass legislation ensuring nothing like this happens again. Have any suggestions there?

Posted by Woltmann | Report as abusive

Financial Regulatory Forum
This article is excellent, it points out banks are in business for profit and gamble with the tax payer money.
This seems to be a major hurdle in reform, as we do not have the political will to say no to bail outs.
i.e., we have no objection to the banks management betting the firm on a profit and loss scheme; after all it is the bank share holder’s cash.
However, the concept and implementation of bailouts is to say the least flawed logic.

Posted by The1eyedman | Report as abusive