Real Clear Politics / Real Clear Markets
November 22, 2011
How Government Props Up Big Finance
By _Marc Joffe & Anthony Randazzo_
(http://www.realclearmarkets.com/authors/?id=22241)
Since medieval times, writers and ethicists have counted envy among the
seven deadly sins. In utilitarian terms, envy is at best a zero-sum game
because it can only be satisfied when someone loses.
Given this moral and practical failing, it is a shame that envy plays such
a large role in the Occupy Wall Street protests spread around the country.
And, yet, the Occupy movement does have a point that transcends this
negative emotion: the financial industry has grown large on the backs of
government handouts, manipulated regulation, and taxpayer bailouts.
While there is no objective size the financial industry should be, it is
fair to say it would never have become this large without the crony
capitalist system that has masqueraded as a free market. In the process, the
financial industry has absorbed resources that could better be used elsewhere
while imposing large, systemic risks on the economy. Watching others grow rich
from special privilege understandably leads to envy, but from this
perspective, the high compensation received by financial industry leaders is
merely
a symptom of a much larger problem.
Big finance has achieved its present girth on the back of numerous policy
decisions - some going back centuries. Many of these policies had the
intention of protecting the general public, but often had the unintended
consequence of enriching bankers beyond the product of their labor.
For example, central banks often seek to encourage growth by lowering
interest rates for small businesses and individuals. But in the process it is
mainly large banks that benefit from higher margins, as the Fed provides
lendable funds at a steep discount - not all of which is shared with borrowers.
Federal policies designed to assist homebuyers also benefit mortgage
investors and grant them taxpayer supported guarantees they will get paid
(bailing out Fannie Mae and Freddie Mac has already cost $182 billion as a
result).
Subsidized mortgages also result in higher home prices - undermining
affordability goals. Over the long term, consumers become more leveraged, while
financial firms collect more interest and fees.
But special privileges to the financial industry predate discretionary
monetary policy and subsidized lending. Indeed, these privileges are so
embedded in our system, they never occur to us. Perhaps the most distortionary
of
these is banking licenses that offer limited liability. Without such
licenses, bank owners would have to use their personal assets to redeem
deposits
if borrowers default. Limited liability reduces the bank owners' risk to
just their initial investment. The large number of state banking licenses
granted during the nineteenth century allowed "one-percenters" of that era to
profit from borrowing and lending, without worrying about large losses.
They could also grow their institutions by making loans to less creditworthy
borrowers, thereby creating systemic risk.
This risk was usually shouldered by depositors, who often lost money during
bank runs. During the Depression, the federal government solved this
problem by creating deposit insurance. FDIC insurance enabled banks to grow
even
more, and it also freed them to take on even greater risks, since
depositors no longer worried about how their funds were being deployed.
As financial institutions have grown and consolidated over the years, some
have become so systematically important that they have been deemed too big
to fail. These institutions are now effectively eligible for bailouts in
which all creditors - and not just small depositors - are made whole while
management can either remain in place, or walk away with all their previous
compensation plus a severance package to boot.
These protections and hidden subsidies have enabled the financial industry
to achieve enormous size and profitability, while placing the overall
economy at great risk. Usually, these protections were accompanied by
regulations such as capital requirements or size restrictions. These
regulations
usually failed to achieve their intended results - especially over the long
term - because financial institutions are able to wear down the restrictions
by lobbying and by hiring away key regulators.
Instead of adding to the quantity of regulation, thereby creating more
opportunities for the financial industry to game the system, we should tame the
financial beast through greater accountability. One way to do this is to
add a 10 percent co-insurance feature to FDIC insurance for deposits above
$10,000. Depositors with $11,000 in a failed bank would receive $10,900;
while those with a $250,000 balance would get $226,000.
Depositors would not be wiped out in the event of a failure, but they would
have an incentive to select banks that are more careful with their money
(while the poorest are still fully protected). Banks would then have to
compete for depositor business, in part, by demonstrating that they have
strong
risk management.
Those with exposure above the FDIC limit should take at least a 25 percent
haircut through the resolution process in the event of a bank failure.
These stakeholders are often large financial institutions, acting as
counterparties, who have the skill and resources to more closely monitor the
banks
with which they deal. This reform would address one of the most disturbing
episodes of the financial crisis: Goldman Sachs' full recovery on CDO
insurance contracts that triggered the AIG bailout. Certainly low and middle
income taxpayers had better uses for this money than awarding it to the highly
compensated financial wizards at Goldman.
Bank managers should also have more skin in the game. If a bank fails or
receives a bailout, directors, senior managers and highly compensated
employees should have to repay creditors or the government at least a portion
of
past compensation they received from their failed institutions -
particularly compensation tied to performance. Fear of impoverishment would
have a
substantial impact on the risk appetites for those leading major financial
institutions.
Finally, federally subsidized or guaranteed loans should be restricted to
the truly needy. Today, mortgages of up to $625,500 can be purchased by
Fannie Mae and Freddie Mac on the federal government's credit card. This
subsidy should be limited to homes that are below the median price for a given
area. If financial industry players want to originate mortgages to members of
the upper middle class, they should be willing to assume the full risk of
providing these loans.
Indiscriminately taxing the rich is an envy-driven policy that only
marginally addresses Wall Street's size, profitability and systemic risk.
Vindication should always be discarded in favor of an effective reprieve.
Policies
that require financial industry participants to shoulder more of the risks
they create will reduce the burden Wall Street imposes on the general
public, will shrink the industry, and will release human talent for higher and
better purposes.
Rather than demotivate the next Steve Jobs, or reduce the resources Bill
Gates deploys to fight AIDS and malaria, let's instead focus the Occupiers'
energy on advocating solutions that truly improve the lives of the 99
percent.
--
Centroids: The Center of the Radical Centrist Community
<[email protected]>
Google Group: http://groups.google.com/group/RadicalCentrism
Radical Centrism website and blog: http://RadicalCentrism.org
