Too big to fail: the Bagehot rule

It has long been a poorly hidden secret that large banks cannot be left to go bankrupt. Walter Bagehot, a 19th century economist and editor of The Economist, designed the solution that remains as relevant today as it was then. The Bagehot rule is that the central bank ought to lend freely to a failing bank, against high-quality collateral and at a punitive rate (see Xavier Vives’ Vox column).

The modern version of the rule adds that shareholders ought to bear serious costs and the managers ought to be promptly replaced. This is exactly what happened with Bear Stearns last March, where another bank, JP Morgan, was used as the conduit for the operation. The cost to the taxpayers was a $1 billion guarantee and a $29 billion loan to JP Morgan guaranteed by Bear Stearns assets. We don’t yet know if this was a taxpayer-financed bailout. If JP Morgan redresses the situation within ten years, the taxpayers will make a profit. If not, US taxpayers will have borne the burden. Bear Stearns shareholders were almost completely expropriated.

As the US economy keeps limping and the housing market deteriorates, most observers believe that there will be many more bank failures. Indeed, in early July, a large Californian mortgage lender, IndyMac, went belly up and was also subjected to Bagehot’s recipe. The possibility that some very large financial institutions, and many smaller ones, will follow provides urgency for the current debate.

The Larry Summers school of thought: Don’t scare off the investors

One school of thought – let’s call it, fairly I think, the Larry Summers School – is that the Fed has been far too tough with Bear Stearns. It has scared investors and managers alike. The result is that investors are now unwilling to provide much needed cash to banks that must rebuild their badly depleted balance sheets while bank managers strenuously resist acknowledging their losses and continue selling their toxic assets. As a result, the whole banking system is in a state of virtual paralysis, which means that borrowing is both difficult and costly.

Lowering the interest rate, as the Fed vigorously did, does not even begin to redress the situation. This all leads to a vicious circle where insufficient credit drags the economy down, which leads to more loan delinquencies, which further impair banks ability to lend. Memories of 1929 immediately come to mind, when the Fed made matters considerably worse by clinging to financial orthodoxy.

This school of thought fears that the same fascination with high-minded principles turns a bad crisis into another nightmare of historical proportions. The Larry Summers School wants the Fed to lend freely and more generously with the goal being to reassure potential investors. If that is done, so goes the argument, banks will be able to rebuild their balance sheets and resume their normal activities. This would signal the end of the now 1one-year old financial crisis as a virtuous circle unfolds – more loans, a resumption of growth and the end of the housing market decline, healthier banks, and more loans.

The Willem Buiter school of thought: They ran into a wall with eyes wide- open

The other school of thought – let’s call it, a bit unfairly, the Willem Buiter School – sees things in the exact opposite way.

The crisis is the result of financial follies by financial institutions that bought huge amounts of products that they did not understand – the infamous mortgage-backed securities and their derivatives – parked them off-balance-sheet to avoid regulation, and made huge profits in doing so. In short, they ran into a wall with wide-open eyes.

Once the all-too-well foreseen crisis erupted, these institutions kept hiding the extent of their losses as long as they could – they are still playing that game – and started to lobby for a bailout from their governments.

The classic credit cycle: Look who’s crying now

This school notes that the crisis is part of a classic credit cycle that involves excessive risk-taking in good times and ends up in tears. The question is: whose tears?

The challenge is to ensure that these are not the taxpayers’ tears. Indeed banks are in a unique position. They used to call for a bailout to protect their depositors, but deposits are now insured in all developed countries. Still, because bank credit is the bloodline of the economy, we cannot let our banking system sink. But once banks know that they can play the high-risk, high-return game, pocket the profits, and let taxpayers face the risks, bailouts provide a temporary relief but set the ground for the next crisis.

Wilder and wilder parties

Bank of England Governor Mervyn King nicely sums up the situation: “'If banks feel they must keep on dancing while the music is playing and that at the end of the party the central bank will make sure everyone gets home safely, then over time, the parties will become wilder and wilder.” Bagehot principles can be applied when one or two banks fail, but when the whole system is under threat, this is no longer an option.

Which school is winning with policy makers?

Both schools have developed consistent views. The dismaying part of the story is that they lead to radically different policy implications.

So far, the monetary authorities have been closer to the Willem Buiter School view, but things may be changing. The most recent bailout of Fannie Mae and Freddie Mac is clearly a soft rescue operation, with no set limits and, so far at least, no penalty on shareholders and managers. Even though Fannie Mae and Freddie Mac are very special institutions with a federal mandate, the Larry Summers School is right to see some glimmers of hope and therefore must be taken seriously.

In most respects, we have gone through a very classic credit boom- and bust cycle. Two cases from the 1990s are worth pondering.

Following years of fast bank credit growth accompanied, as should be, by housing price bubbles, bank crises started in 1990 in both Japan and Sweden. The Swedish authorities reacted swiftly, bailing out most banks at a cost to taxpayers estimated at some 4% of GDP, but shareholders were essentially expropriated.

The Japanese authorities protected their banks with generous loans, even as some banks were serving dividend payments to their shareholders.

Sweden recovered in three years and, nowadays, Swedish banks are not found among those that indulged in mortgage-backed securities. Japan has still not recovered from a nearly twenty-year long “lost decade” and, nowadays, several Japanese banks have already failed under the weight of the toxic assets that they acquired, once again.

Figure 1: GDP Growth in Japan and Sweden



Source: Economic Outlook, OECD

Conclusions

Of course, there is more to it than this simple comparison, including the accompanying macroeconomic policies. But three unmistakable messages emerge.

1) Be merciless with shareholders and gentle to bank customers. 2) Either way, taxpayers are always the losers. 3) Bagehot had it all right.

Peter Englund, “The Swedish Banking Crisis: Roots and Consequences”, Oxford Review Of Economic Policy 15 (3): 80-97.