Calming the panic in short-term funding markets was a significant part of the response to the 2008 financial crisis. While the TARP bailout programs received the most attention during the crisis, TARP never exceeded one-fifth of the government’s overall financial stability programs, which peaked at $2.4 trillion. These markets were abstract and esoteric to most Americans, but their preservation, it was argued, was crucial to preserving the financial well-being of workers, homeowners, and small businesses. As Professor Judge notes, however, the “perception that the Fed’s interventions looked out for Wall Street over Main Street has been an ongoing source of consternation for many, and a contributing factor in a subsequent popular backlash.”
In response to this backlash, the Wall Street reform legislation sought to remake some of these programs, but as Ben Bernanke said a few years ago, “Too Big To Fail is not solved and gone. It’s still here.” If Too Big to Fail is indeed still with us, and we are still at risk of facing another crisis in our lifetimes, then Professor Judge’s economic guarantee authority (EGA) proposal is important because it forces us to think about why such emergency financial support programs exist, and how they can accomplish the dual aims of preserving financial stability and democratic legitimacy.
I should begin by saying that I disagree with a central premise of the article, that “regulation simply cannot keep pace with financial innovation,” particularly as applied to the fragility of the financial system. Requiring all financial institutions to fund themselves with more of their own shareholders’ equity would reduce the share of their liabilities that are comprised of fragile short-term funding and reduce the funding pressures if and when any short-term funding begins to run on them. Coupling more capital with a limit on the amount of non-deposit funding used by any single institution would drastically reduce the fragility of the financial system. When innovation risks getting out of control, there are other ways of slowing it down. In short, I don’t think the problem is that we can’t address these problems, it’s that we haven’t had the will to take the necessary steps to do so.
Having said that, I agree that financial regulation, including recent examples of deregulation, is not meeting the challenge of preventing excessive fragility that the EGA seeks to address. After the crisis, regulators focused their efforts on ensuring that the largest, most complex bank holding companies are more resilient, enacting several layers of new capital requirements, supervisory stress testing, and two leverage ratios. To address pressures from short-term funding, they now require a pool of liquid assets that can quickly be converted into cash and proposed a minimum ratio of long-term, “stable” funding. Finally, to reduce potential spillovers caused by failure, they have created a new framework for banks to convert a class of debt into equity in order to recapitalize in the orderly liquidation process.
I believe that these layered rules are unlikely to work because they contain too many moving pieces and too much micromanagement of banks’ balance sheets, and the rules that are likely to be the most effective (i.e., increasing their equity funding and reducing their reliance on borrowed funds) are not robust enough. But as Professor Judge notes, my pessimism is beside the point: EGA is really a “crisis management device, not a mechanism for preventing or solving crises.” Given the world as it currently exists, I agree with her that an EGA could be a reasonable evolution in crisis response.
Post Dodd-Frank, the Fed’s 13(3) authority is limited to programs with broad-based eligibility, prohibited for insolvent institutions, and subject to enhanced transparency and reporting requirements, and Professor Judge explains the distinct roles played by secured lending and guarantee programs. But Dodd-Frank also limits the FDIC’s guarantee authority by requiring that assistance pursuant to a systemic risk determination only be made to banks that have been placed in receivership, suspending the FDIC’s ability to create broad-based guarantee programs, and establishing an FDIC guarantee authority for insured depositories where the Treasury secretary has determined that there is a “liquidity event.” This appears to constrain the safety net to certain institutions and circumstances, but will those constraints remain in place in the depths of a full-on crisis? I’m skeptical. While financial crisis policymakers have argued that these tools are too rigid, Federal Reserve staff has acknowledged that it could once again assist, for example, the repurchase agreement, commercial paper, and other credit markets if they became severely strained.
If the public is going to be on the hook in one way or another for rescuing the entire financial system in a panic, I agree that it’s better to have one comprehensive authority that is well designed and subject to oversight and accountability, rather than disparate programs that are stretched to their legal breaking points in idiosyncratic events. Some could argue that an EGA is an unwise expansion of the safety net to nonbanks, but in many ways we’re already there. With that in mind, I’ll propose some potential revisions to EGA that seek to address the issues of accountability, moral hazard, and fairness.
First, governance and accountability are important because they ensure the program’s legitimacy, while also allowing for proper administration. Arguably, one of the Treasury secretary’s greatest responsibilities, after the crisis, is her role as the chair of the Financial Stability Oversight Council. All Treasury nominees should be required to testify before the Senate Banking Committee to explain how they would carry out their responsibilities as FSOC chair, including articulating how, if confirmed, they would exercise the EGA.
Once confirmed, the secretary could periodically explain any evolution of her thinking about the EGA program in the FSOC’s annual report on risks to the financial system. This would provide opportunities for democratic buy-in and accountability: The confirmation of a secretary is an implicit congressional blessing of her approach to using the EGA, and her statement and annual reports would articulate policies against which her future actions could be judged.
In a final measure of accountability, the secretary could be statutorily required to submit her resignation on a set date after the expiration of the EGA. This type of mechanism would send a strong signal to the public that their public servants are being held accountable for their actions and missteps. It would be the president’s decision to accept or reject her resignation, make the case to the public justifying that decision, and then accept the political consequences. This would be similar to the U.K.’s parliamentary system, where votes of no confidence and resignations by governmental leaders are more routine than in the U.S., for example, after the failed Brexit vote. If millions of Americans are going to lose their jobs (and possibly their homes) in a financial crisis, why shouldn’t the policy maker with the greatest responsibility for safeguarding the financial system also lose hers?
In recent years, the FSOC has retreated from designating any financial companies as nonbank SIFIs. In the way that “living wills” force bank management to consider their own corporate mortality, forward-looking EGA reporting would focus the secretary’s mind on the possible causes of, and responses to, the next crisis. Holding the FSOC chair personally responsible for any contagion that arises – particularly in the “shadow banking” sector – could motivate the FSOC to re-engage its full set of tools and responsibilities.
Second, dealing with the potential moral hazard created by the existence of an EGA, as well as other explicit and implicit guarantees, is an issue that is often explored but which has implications that are still not fully understood. As a starting point, there are some potential lessons to be learned from the financial crisis programs, including that a program’s implementation is as important as its design, as demonstrated by the work of the TARP Inspector General. With that in mind, participation in any guarantee program should require companies to agree to executive compensation limits akin to those provided by the TARP legislation and the TARP Special Master’s office, in particular clawbacks, golden parachute prohibitions, and limits on incentive compensation for a set period, including after their participation has ended. In addition, recipients should be required to issue new equity before exiting the program, as supervisors did with the largest TARP recipients. While policymakers during the crisis bristled at calls for “Old Testament” justice, these conditions are important to address the potential for “heads I win, tails you lose” risk taking and reinforce the public’s confidence that the system works in an evenhanded way.
Structuring the guarantee fee or assessment associated with the EGA is another way to influence firms’ financial incentives. As Professor Judge notes, some crisis programs lost money, notwithstanding the fees that they collected. Subsequent studies of bailout programs have shown that they offered financially beneficial terms relative to the “market rate” available at the time, including for debt guarantees. Still further studies have sought to quantify the ongoing, implicit support enjoyed by large financial institutions as a result of the perception that they’ll be rescued again. Ensuring that an EGA is supporting the healthy functioning of the financial system while also discouraging excessive risk taking is an area for ongoing research, study, and refinement.
Based upon recent experience, I’m less optimistic that EGA recipients would be faced with a choice between “inviting massive reforms … or demise.” For example, money market mutual funds were an important part of the financial crisis. However, it took until November 2012 – over four years after the first money market mutual fund “broke the buck” – for FSOC to exercise its recommendation authority to propose a series of reforms to money market funds. Because this provision uses permissive rather than mandatory authorities to persuade regulators to act, it took more than 18 more months for the SEC to finalize its money market fund reforms. Meaningful reforms often take too long and come up short when they eventually happen.
Consistent with the view that you “never want a serious crisis to go to waste,” use of the EGA should come with an automatic trigger for heightened regulation. For example, recipients could be designated by the FSOC on an emergency basis, automatically triggering the law’s emergency waiver provision. In such a circumstance, the conditions that “material financial distress … could pose a threat to the financial stability of the United States” having been satisfied by the invocation of the EGA. (Some clarifying language in the law would probably be helpful on both of these points.)
Finally, back to the question of fairness, in particular which people or institutions are judged to be worthy of rescue and which are not. Any effective EGA needs to pair a credit market guarantee with a corresponding mechanism that benefits consumers, workers, or communities. An example might be automatic mortgage principal or payment reduction when housing prices fall precipitously. When Treasury Secretary Geithner characterized homeowners in the mortgage modification program as “foam on the runway,” creating a soft landing for banks that needed to slow or stem mortgage losses as they sought to recapitalize their balance sheets, he acknowledged that such programs provide substantial macroeconomic benefits. Despite these benefits, too few low- and moderate-income Americans saw any direct benefit from the government’s rescue programs.
The critical lesson from the crisis era rescue programs, as Professor Judge puts it, is that there is no “purely technocratic solution to the messy and difficult tradeoffs crises inevitably pose.” It isn’t inevitable that we need to win the war on financial crises, only to lose the peace, as we seem to have done in the last crisis. Well-designed prudential regulations and crisis management tools can help our nation’s leadership in its effort to lessen the likelihood of disasters and manage the fallout when they happen, while at the same time “help[ing] restore the close relationship with its people which is necessary to our democratic form of government.”
 Federal Reserve officials also discussed applying universal haircuts to all securities financing transactions, in order to prevent the buildup of leverage in certain short-term wholesale funding markets, but that has not yet become a formal proposal (if it is still under consideration at all).
 Because of the historical significance of the Treasury secretary’s fiscal portfolio, nominees typically testify before the Senate Finance Committee.
 Despite the numerous reports on bailouts, the narrative is already muddled 11 years later. Even self-appointed “fact checkers” are confused about what exactly happened and the degree of generosity shown to Wall Street during the bailouts.
 In an ideal world, the Office of Financial Research would contribute its expertise to the design of EGA fees and assessments, to measuring the program’s costs, and to other implications of the program after the fact. To date, however, the OFR has failed to deliver on its promise, in part because it lacks sufficient independence, but this is an area where an independent and competent OFR would be valuable.
This post comes to us from Graham Steele, director of the Corporations and Society Initiative at Stanford University’s Graduate School of Business.