Why the Fed Should Just Let Bad Banks Die

Arif Ali/AFP/Getty Images

Arif Ali/AFP/Getty Images

When Ben Bernanke began his tenure as Chair of the Federal Reserve in 2006, America didn’t know much about this academic-turned-public servant. Once Chair of the economics department at Princeton University, Bernanke did a stint on the Fed Board of Governors and served as Chair of the Board of Economic Advisers under President George W. Bush. At the time, Bernanke was seen by many as Greenspan Lite, an economist of the same persuasion as the notoriously libertarian leaning former Fed Chair but with a softer touch.

The perception was fairly accurate. Bernanke, along with Greenspan and much of the economic hegemony at the time, did champion a light approach to financial regulation. As a result, the fermenting financial crisis escaped notice or consideration by many, if not most, of the world’s top economists until about 2007 when it was too late to stop.

The root cause of the problem was obvious: the financial sector had become bloated, unstable, and misguided. Worse yet, financial gluttony was fed in part by the Fed itself. Not only had the central bank championed financial deregulation — Glass-Steagall was infamously repealed in 1999 — but it had kept the target federal funds rate low for a long period. Critically, this drove interest rates on mortgages down and helped fuel the sub-prime lending frenzy that fueled the crisis.

To his credit, Bernanke acted swiftly and severely to try to minimize the fallout — and, love him or hate him (I try to maintain a calculated mix of deference and disinterest myself) his actions helped steer the U.S. economic leviathan through the storm. Many in the economic and political hegemony credited Bernanke with routing a second Great Depression.

But in order to do so, Bernanke employed aggressive and unconventional monetary strategies. You may have heard of quantitative easing (QE) — a program through which the Fed is purchasing agency mortgage-backed securities and longer-term Treasuries in order to keep longer-term interest rates low and therefore stimulate spending in interest rate-sensitive sectors like housing — but this is only part of the picture, and really not even the most interesting part. Before QE, before any of the asset-purchase programs, the Fed orchestrated a $7.7 trillion bailout of the financial sector, and it’s the thinking behind this bailout that is the most interesting part of the picture.

Here’s why: no one really seems to be sure if the Fed is supposed to actively engage in the markets in the name of financial stability. “Should the Fed Have a Financial Stability Mandate?” is even the title of a recent research publication for the Federal Reserve Bank of Richmond. The report unpacks the evolution of the financial safety net — the size of which alone suggests the presence of moral hazard — and how events came to a head during the crisis. With a few notable exceptions — like Lehman Brothers — the Fed did exercise its enormous and controversial power to bail out the financial sector. The result was the preservation of financial stability, but the implications are still being worked through and debated.

The central controversy revolves around this idea of moral hazard — that financial institutions will take inappropriate risks if they believe that there will be a safety net to catch them in the event of a catastrophic failure or economic shock. Moral hazard is related to the idea “too big too fail,” which deals with financial institutions so large and interconnected that their failure would cause massive harm to third parties or the economy at large. Due to this, regulators, ostensibly, cannot allow the failure of such institutions. This implies a safety net, which implies moral hazard, which breeds the institutional bad behavior that leads to crises.

This line of thinking has been rigorously followed, criticized, and expanded in the wake of the crisis, but the concept is as old as central banking itself.  The authors of the Richmond Fed’s report, Renee Haltom and Jeffery Lacker, write that, “The moral hazard that results from government support is not a new revelation. Dating back to the 1930s, policymakers have acknowledged it with virtually every step that expanded or reinterpreted the government’s reach. From the Depression to the bank failures of the 1970s and 1980s, major crises have prompted sweeping reforms to constrain risk-taking and prevent future financial distress. Yet, at each turn, policymakers have been unwilling to relinquish the ability to funnel credit to particular markets and firms in perceived emergencies. One can understand why, because such lending, by confirming hopes for intervention, appears to stabilize markets as it did in 2007 and 2008. The approach instead has been to retain that power and attempt to counter moral hazard with enhanced supervision.”

Large financial institutions — those designated as systemically important by the Dodd-Frank Act and others — know that the Fed has this power and that it is addicted to using it. Why not? As the Richmond report explains, exercising extraordinary bailout facilities may have consequences but it does appear to do the job — it may be a fuck-all last-ditch solution, but it’s better than total financial catastrophe and months, if not years, of economic depression.

But here’s why not: one of the underlying problems leading to financial destabilization is the fact that the Fed has these powers to begin with. If the Fed has them, the Fed will use them “in perceived emergencies,” and the problem of moral hazard is therefore unaddressed. Moreover, so-called “safety and soundness” regulation such as the Dodd-Frank Act falls short, as admirable as the spirit of the law is. Dodd-Frank is a piece of legislation designed to end too big to fail, and while it makes great strides toward ensuring the safety and soundness of the financial sector by imposing new restrictions and reporting standards, it does not address the problem of perverted incentives.

“The real lesson of the Fed’s first 100 years,” writes the Richmond Fed, “is that the best contribution the Fed can make to financial stability is to pursue its monetary stability mandate faithfully and abstain from credit-market interventions that promote moral hazard.”

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