Yesterday, top Treasury official Herb Allison testified before the Congressional Oversight Panel. Simon Johnson and Felix Salmon are disappointed in his testimony. I think they're missing the point. Both are mad that Allison said that "there is no too-big-to-fail guarantee on the part of the U.S. government," not because they think that is a bad policy but because they assume that this is a lie and the government will bail out financial institutions that fail in the future. Johnson gets extremely worked up, and in typical fashion takes Allison's comment out of context, saying it is a "barefaced misrepresentation" of what the government did in the past two years. In fact, Allison was saying that going forward, the government's policy is not to bail out banks; he wasn't looking backward at past decisions. This "no guarantee" policy is reflected in the administration's support for regulatory reform that would create restrictions on bank risk-taking, scope and size, as well as its desire to give regulators the authority to wind down and liquidate failing firms.
Salmon complains about the recognition of Tier 1 Financial Holding Companies, the largest and most interconnected financial firms that the administration believes deserves extra-tight regulation. He writes:
There’s only one reason why the government should carefully regulate a set of companies so as to ensure that they don’t fail. And we all know what that reason is: if they were ever to fail, the government would be forced to step in and bail them out.
That's not right at all. We supervise and restrict all kinds of risk-taking in the financial sector and elsewhere, not because the government will bail out anyone that fails but because that risk can damage broader society. If we were to somehow break up the financial sector to the point where no institution could hurt the broader economy if it failed, would that be a reason to simply lift all financial regulation? It's not only common sense that large institutions should be more carefully regulated, but the other part of that idea is that banks, unwilling to accept that level of scrutiny, will do their best not to become Tier 1 FHCs. Meanwhile, the Obama administration is pretty committed to not bailing out insolvent banks -- look at the House bill, which forbids government loans to insolvent institutions and wants to use dissolution authorities to wind them down.
Of course, the House bill isn't law yet. What happens if there is no regulatory reform before another major bank fails? Well, the markets supposedly believe -- Lord, save me from trying to divine what "the markets" "believe" -- that bailouts could come again because policymakers would face the same limited options as last time. But another bank bailout would be politically disastrous for the Obama administration -- can you even imagine? They would probably find a way to let the bank fail or broker some kind of forced merger with another institution. Also, total speculation alert, this is why a number of market subsidies still exist for the banks even though they are doing all right these days: No one wants a bank to fail before the new system is in place.
This puts Allison in a tough place. He's speaking accurately about what the administration's policy is. But for years the Treasury and the regulators have said "no bailouts" and then bailed people out. It's not a crazy assumption that a bailout could come in the future, though I think it is an unlikely one. So what's an official to do? Take it away, Herb:
The key question is: how does Treasury avoid having to provide assistance to institutions like Citigroup again?Today, the financial system is operating under the same rules that led to its near-collapse and to this deep recession. These rules must be changed to address the moral hazard posed by large, interconnected financial institutions considered "too big to fail." The administration has proposed comprehensive financial reforms that seek to address this moral hazard by forcing these institutions to internalize the risks they impose on our financial system and to remove expectations of government support.
Sounds exactly like the answer to Johnson's question about why Treasury thinks we need new laws.
-- Tim Fernholz
