While deliberating new banking rules that might mitigate future financial crises, U.S. lawmakers and banking officials considered and rejected a plan to have banks put funds upfront into a fund that would pay creditors and depositors should a large bank fail. Some financial-industry analysts say that such advance preparation for the likely inevitable failure of more big financial firms down the line is a plan well worth pursuing.
“An advance-payment bailout fund was a House proposal that didn't get nearly enough attention,” says Dean Baker, chief economist at the Center for Economic and Policy Research, a liberal think tank. The final congressional bill instead included what Baker calls a misguided proposal to have banks ante up such funding only after financial firms actually crash.
Having such a fund available before a crisis “would allow the regulators to shut down” ailing institutions in a quick, orderly fashion before problems worsened and spread, Baker says, Without it, “regulators won't have the tools to shut down” ailing big banks. Furthermore, the plan is a proven idea “that we already have in place” in the Federal Deposit Insurance Corporation (FDIC) and use routinely for smaller banks, Baker says.
Without an advance fund, if a big bank fails, “government regulators can go to Congress and ask for money” to address that specific emergency, “but Congress might say they don't want to provide the money” or ask the financial industry for it, or the request might get tangled up in a legislative logjam of some kind, he says.
The provision might not be needed if the only problems in the system came from a handful of “rogue institutions,” says Baker. “But what we got in 2008 was not rogue. You didn't so much have rogue players as a system that was totally out of whack,” he says. “A fund that's ready and waiting would be a backstop” for the day when a large firm was “suddenly insolvent.”
When failing banks are closed, the money to pay creditors “shouldn't take the form of a post-crisis tax,” says Amy Sepinwall, an assistant professor of legal studies and business ethics at the University of Pennsylvania's Wharton School. “I think there should be a perpetual tax on the players” in recognition of the fact that, no matter what laws and regulations are in place, there will always be the possibility of some financial institution taking too many risks and failing.
“People on Wall Street are incredibly intelligent” and may “develop strategies to circumvent whatever rules Congress” puts in place to rein them in, says Sepinwall. “Maybe that's the way it's supposed to be,” since the circumvention often leads to innovation, some of which is very valuable. At the same time, however, it's obvious that some financial-market innovations will be extremely risky, she says.
For that reason, requiring regular payments from the whole industry into a fund that could serve as a backstop for firms whose innovative financing arrangements go south is probably a good idea, she says. “One could key the tax to the size of the bank,” she says. Such an upfront fund would constitute a “recognition of the principle of ‘moral luck’” — the idea that, while many people may drink and drive, for example, only some will have an accident, but that everyone who engages in the risky behavior, not just those who crash, actually bears some degree of responsibility, Sepinwall explains.
Like Congress, finance ministers and central-bank chiefs of the G20 — 19 nations and the European Union — considered but rejected an international version of the bank shutdown fund in deliberations this summer. Given the increasingly international nature of the financial system, the European Union and some others want each country to tax its banks to create a pool to be used to resolve failed banks, to avoid delaying the process or sticking taxpayers with the bill.
Some countries that impose limits on how much risk banking institutions may take on, such as Canada, object to the idea. They argue that “since their regulatory systems are strong,” their local institutions “shouldn't have to pay for what happens in riskier countries” without the foresight to ban risky practices up front, says Sepinwall.
In the U.S. debate over financial reform, key congressional Republicans persistently demanded that the fund be removed from the bill on the grounds that it might actually be used to keep faltering institutions alive. “The bill reported out of committee sets up a $50 billion fund that, while intended for resolving failing firms, is available for virtually any purpose that the Treasury secretary sees fit,” wrote Alabama's Sen. Richard Shelby, the top-ranking Republican member of the Senate Banking Committee. “The mere existence of this fund will make it all too easy to choose bailout over bankruptcy. This can only reinforce the expectation that the government stands ready to intervene on behalf of large and politically connected financial institutions.”
The fact-checking website PolitiFact notes, however, that Shelby's statement — which was widely echoed by other Republican and conservative commentators — ignores specific bill language that bans use of the funds for any purpose except those connected with closing large firms that falter. “The legislative language is pretty clear that the money must be used to dissolve — meaning completely shut down — failing firms,” said PolitiFact. “The fund cannot be used to keep faltering institutions alive.”
— Marcia Clemmitt