Louisiana Governor Bobby Jindal, a possible 2016 Republican presidential contender, is on to something when he says Republicans must rethink their approach to financial reform. For one thing, the Obama-Dodd-Frank law probably doesn’t prevent future bailouts of large financial institutions. One example: A key provision of the law prohibits the Federal Reserve from bailing out individual financial firms. But, as AEI’s Peter Wallison points out, the law also permits the new Financial Stability Oversight Council “to designate any financial institution that is engaged in clearing, settlement or payments activities — that is, almost every bank of any size — as eligible for a Federal Reserve bailout if its financial condition might prevent it from performing these functions.”
Where there’s a political will, politicians will find a way. Indeed, the funding costs of the largest banks continue to be lower than that of smaller rivals, one piece of evidence suggesting lenders still view them as having a government backstop. True financial reform should have as its goals enhanced financial stability and the mitigation of moral hazard. I think part of the answer is a restriction on the types of activities allowable for banks with access to the federal safety net of deposit insurance and Fed discount window. Another, perhaps complimentary, approach is outlined in a 2009 paper by Atlanta Fed economist Robert Hetzel. His proposal for a “severely limited safety net” is as follows:
1. The government must commit not to bailing out the creditors of financial institutions, especially those of large banks. If a bank experiences a run, the chartering regulator must put it into conservatorship.
2. Under conservatorship, regulators assume a majority of seats on the bank’s board of directors. The directors then decide whether to sell, liquidate, break up, or rehabilitate the bank. By law, this conservatorship must eliminate the value of equity and impose an immediate haircut on all holders of debt and holders of uninsured deposits. Thereafter, as long as the bank is in conservatorship, the existing deposits and debt are fully insured.
3. After being placed into conservatorship and after the haircuts imposed on holders of the bank’s debt, the bank could still be insolvent as indicated by a lack of bidders for the bank without government financial assistance. In this event, the regulators would levy a special assessment on banks to recapitalize the failed institution.
4. Essential to eliminating the ability of government to bail out the creditors of banks is elimination of the legal authority of the Fed to make discount window loans.
At first glance, this might look like a recipe for a first-class financial panic, particularly with an apparently neutered Fed. But the central bank would actually be key to making Hetzel’s limited safety net work:
Even with a credible commitment not to bail out banks and without a discount window, the Fed would continue to play a critical role. A lesson from history is that severe financial panics require monetary stringency. The Fed needs to follow a rule that allows the price system to operate to smooth cyclical fluctuations. In the event of a panic, the Fed would engage in massive amounts of open market purchases to assure markets that liquidity will remain available. With its ability to pay interest on reserves, the Fed can now buy unlimited amounts of assets without depressing the funds rate.
In addition to providing liquidity, Fed bond-buying would stabilize expectations about future economic growth. Indeed, the limited safety net would seem to need a policy pairing with NGDP targeting as the clear basis of monetary policy.
Overall, I think Hetzel is too confident that Washington wouldn’t ride to the rescue. He says that a decision by Treasury Secretary “to bail out a large bank would require asking Congress for funds. Congressmen would then have to vote explicitly for income transfers that run counter to a long populist tradition distrustful of the concentration of wealth on Wall Street.”
It’s happened before, it can happen again, which is why the Hetzel plan would work well with the bank restructuring plan outlined by FDIC director and former Kansas City Fed president Thomas Hoenig. Hetzel plus Hoenig would be true financial reform and put an end to bailouts and Too Big To Fail. Jindal, and other Republicans, should take a look at both plans.