Not allowing poorly run large banks to fail presents a number of risks to the U.S. economy; principally, (1) prolonged taxpayer support for ailing institutions, (2) anemic innovation in the financial services sector, and (3) disincentives for better management of financial institutions. Indeed, hidden support for many institutions in the form of low interest loans from the Federal Reserve Bank and ongoing mortgage capital from Fannie Mae and Freddie Mac already created an environment of risk-taking with taxpayer funds with little downside to the financial institution.
During the current credit crisis, not every bank in the United States became insolvent or neared insolvency. In fact, thousands of community and regional banks, and some large banks such as J.P. Morgan and Wells Fargo, are continuing to make money, although less than before the credit crisis. There are also some colossal failures such as IndyMac and Washington Mutual, made more dramatic by news headlines likening the current environment to the Great Depression. Those analogies an inapt - during the Great Depression thousands of banks failed and there was no deposit insurance, the Federal Reserve increased interest rates, and global trade ground to a standstill under the Smoot-Hawley Tariff Act, a misguided attempt to protect domestic industries leading to disastrous consequences.
The federal bailout bill pledging $700 billion for the Treasury to allocate to support the banking sector presents a significant challenge; namely, rather than lowering the risk in the banking sector by bank failures, it could heighten the risk by lengthening the lives of large banks that are considered “too big to fail.” Currently, the Treasury is proposing to devote $250 billion of the $700 billion available to (1) guarantee 100% of senior unsecured debt of certain banks for three years, (2) expand federal deposit insurance to some business deposits, (3) purchase bank commercial paper, and (4) purchase preferred stock of participating banks, which preferred stock will carry a 5% dividend. In addition, the participating banks will limit their executive compensation, be required to lend a certain portion of their new capital, and face certain restrictions on paying dividends on the bank's stock not owned by the government.
$125 billion of the $250 billion allocated to this program is targeted to just 8 large banks, including two -- J.P. Morgan and Wells Fargo - that are still profitable notwithstanding taking billions of write-downs on their mortgage portfolio. The requirements imposed on the banks accepting the funds are not onerous. For a bank near to failing, these funds are a lifeline even if the conditions imposed by the Treasury are an inconvenience.
The central problem with such a program is that no distinction is made between solvent and insolvent banks. The insolvent banks demonstrated poor management and should be closed down or merged with a stronger bank; however, closing banks does not seem to be a priority in this program. There are some large banks in the United States, and were one or more of them to fail, the confidence in the banking sector would be severely shaken; however, to avoid an ongoing risk to the system those weak banks should be closed, and quickly with decisive action by the federal bank regulators and the FDIC. The Treasury's plan is going to allow banks that are perceived as “too big to fail” to limp along until the next challenge to the banking sector. Thus, restoring confidence seems to be supporting all institutions, weak or strong.
Prolonging the life of weak banks that are “too big to fail” continues a threat to the taxpayer of a larger bailout at a later time. Such a policy will lessen innovation in the banking sector, but providing a false imprimatur of security to the surviving weak banks. Those banks will continue to draw deposits and present competition to the better run banks, even though those weak banks had proven themselves unworthy of customer deposits. Finally, those weak banks can continue managing their assets as they have in the past and survive in the competitive marketplace. The incentive for better management is lost if poor managers can continue managing their institutions after bringing them to the point that they should be dissolved. “Too big to fail” is a policy that promises a bigger failure in the future.
