Politics, Not Policy, Will Decide Who Gets Bailed Out

What can we do about “too big to fail”?

The interim report of the Commonwealth’s Financial System Inquiry, chaired by David Murray and released last week, spends a fair bit of time talking about this puzzle.

“Too big to fail” describes financial institutions, mostly banks, which have become so large and so deeply integrated into the financial system that if we let them collapse they would take everything else with them.

If a corporation is too big to fail, then, it follows, taxpayers have to bail them out.

It’s quite a problem. A market economy is supposed to be dynamic, full of entries and exits. Firms that add economic value thrive. Those that do not go broke.

So bailing out failed companies makes the economy less efficient. More gallingly, it redistributes money from the poor to the rich. And it creates “moral hazard” – a belief by management that ultimately they won’t have to pay for their mistakes.

Moral hazard is a particularly severe problem for banks. Banks trade on risk. A bank’s basic job is to transform short-term highly liquid deposits into long-term extremely illiquid loans. Too much of the latter will prevent redemption of the former.

Too big to fail encourages banks to make riskier loans. Why wouldn’t they? They’re not the ones bearing the cost of failure. Taxpayers are.

So it would be great to get rid of too-big-to-fail. Or at least limit it somehow. The Murray Inquiry has a few ideas: higher capital requirements for bigger institutions, for instance, or new procedures for when banks do fail.

But the question isn’t what should we do about too-big-to-fail but what can we do about it.

And the answer to that question is almost certainly nothing.

Because no matter what the Murray Inquiry recommends – no matter what policy the Government or Reserve Bank or Australian Prudential Regulatory Authority imposes today – the decision of which firms to bail out and which to let fall will be made by the policymakers of the future, according to their own whims, and mindful of political, not economic, considerations.

Simply put, there are no ways to credibly constrain future governments from deeming an institution too big to fail.

Nowhere is that clearer than in the United States.

After the savings and loans crisis of the late 1980s, American policymakers decided to put some limits on the availability of government bailouts. The result was the Federal Deposit Insurance Corporation Improvement Act 1991. This law was supposed to set rules under which an institution would be considered too big to fail.

But those carefully constructed limits fell apart when the Global Financial Crisis hit. Consumed by panic, the American government bailed out not only banks but money market funds and Fannie Mae and Freddie Mac – two bodies that were theoretically and legally owned by private shareholders but were implicitly backed by a government guarantee.

Now American policymakers say they’ve come up with a new system supposed to constrain too big to fail – the 2010 Dodd-Frank Act. Will it work? Don’t bet your house savings account on it.

We’re lucky in Australia to have gone the better part of a century without a high-profile bank failure. But we’re hardly immune to the political pressures that have created the too big to fail problem.

One predecessor of the Murray Inquiry, the Fraser government’s Campbell Committee, argued the responsibility of the government is to keep alive the system as a whole, not prop up individual institutions. Banks should be allowed to go under.

But who gets bailed out is a decision made by politicians not economists.

In 1990 the Farrow Group – a Victorian group of building societies whose most prominent member was the Pyramid building society – got into serious trouble. In July 1990 John Cain’s Victorian government gave it the bailout it wanted, guaranteeing more than $1 billion of unsecured deposits. (The full story is told in this paper).

Was the Farrow Group too big to fail? The Cain government said it was – it was “systemically significant”, to use our contemporary econocrat buzzword.

Systematic significance is a term of art, and not a very clear one. Since the Global Financial Crisis systematic significance has become a totem of financial regulation. The idea is that too big to fail isn’t just about size, but more about integration.

There’s been a cottage industry of academics trying to figure out how to tell which institutions are systemically significant.

No doubt they’re all doing great, insightful work. But the fact remains these studies of systemic significance are just a lot of after-the-fact reasoning.

It was policymakers – not scholars – who came up with the idea that some institutions were just too interconnected with the financial system to collapse peacefully.

Like pornography, politicians and bureaucrats know systemic significance when they see it. The Victorian government just knew the Farrow Group was too important to collapse. The American Federal Reserve just knew that they had to bail out the private money market funds.

Yes, systemically significant institutions get bailed out – but their significance should refer to the political system, not the financial system.

No matter what the Murray Inquiry decides, in the middle of a panic political expedience is going to beat carefully crafted rules every time.