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Banking on Bailouts: evaluating the current Federal Reserve’s crisis response.

TL;DR: As the Federal Reserve's Bank Term Funding Program (BTFP) skyrockets to $103.08 billion, concerns escalate about the U.S. government's financial backing of struggling banks. This article delves into the complexities of this intricate issue, tracing the history of bailouts, exploring their potential benefits and pitfalls, and critically examining their current and future roles in our economy. Should we continually bail out institutions that would otherwise collapse? Are we fostering a culture of risk without consequences? These pressing questions are unraveled against the backdrop of an evolving financial landscape, where the decisions we make today will impact not only the future of the U.S. financial system but the global economic stage as well. Dive into this engaging discussion and arm yourself with a comprehensive understanding of the multi-faceted world of bailouts.

Banks & Bailouts.

The United States' financial landscape has recently been under significant media attention, largely due to the recent banking crisis and subsequent Federal Reserve Bank Term Funding Program (BTFP). As the program reaches a weekly high of $103.08 billion, concerns have arisen regarding the extent and nature of government support for struggling banks. These concerns highlight a broader question: to what extent should the government support financial institutions that may otherwise collapse under market forces? This program, it's worth noting, was initiated in response to a banking crisis that brought several substantial financial institutions, such as the Silicon Valley Bank, to the brink of collapse. In this paper, we will navigate through the complex terrain of these issues, exploring the history of bailouts, the current state of the BTFP, and the potential future of government interventions in the financial sector.

What is the BTFP?

The BTFP is a tool designed to assist small community banks—those with less than $1 billion in assets—in complying with a new accounting standard, the “current expected credit loss” (CECL) methodology. This new standard, which banks are required to implement by 2023, fundamentally changes the way banks set their loan loss allowances.

The CECL methodology was introduced as a response to the financial crisis of 2007-2008, during which it became apparent that banks’ balance sheets did not adequately reflect the inherent risks in their loan portfolios. Under CECL, banks are mandated to set aside funds to cover potential losses over the lifespan of an asset as soon as it is booked, rather than when it becomes probable that a loss will occur. To set aside these loan loss reserves, now formally known as the allowance for credit losses (ACL), banks rely on historical experience, current conditions, and "reasonable and supportable forecasts."

While the objective of the BTFP is to stabilize the banking sector and protect the broader economy from a potential crash, critics argue that the program may have unintended and potentially harmful consequences. One such critic is market analyst Joe Consorti, who argues that the Federal Reserve's "shadow liquidity" is promoting risky behavior across markets. The argument is that, in an attempt to stabilize the banking sector, the Federal Reserve may be inadvertently encouraging investors to take larger risks, potentially leading to a vicious cycle of financial instability and the need for further bailouts. Consorti even suggests that a new facility may be required to manage distressed commercial real estate loans and commercial mortgage-backed securities.

Should We Bail Out Financial Institutions?

These critiques raise a pivotal question: should we bail out financial institutions? This question is not a novelty; it has long been a source of fervent debate among economists, policymakers, and the public. To further explore this question, we must delve into the history of bailouts and evaluate their pros and cons.

A Brief History of Bailouts.

The practice of bailouts in their current form in the United States can be traced back to the 1970s. They have been deployed across various sectors, ranging from railroads and airlines to the automotive and financial industries. The Penn Central Railroad bailout in 1970 stands out as one of the first significant instances of government intervention during a financial crisis. On the brink of bankruptcy, the railroad appealed to the Federal Reserve for aid, arguing its crucial role in national defense transportation services. Despite initial support from the Nixon administration and the Federal Reserve, Congress rejected the measure. Although the railroad declared bankruptcy, the Federal Reserve intervened to support the broader financial market, indicating a willingness to step in amid financial instability.

Since then, bailouts have become a common tool for the government to prevent economic collapse and protect jobs. For example, in 1971, Lockheed received funds provided under the Emergency Loan Guarantee Act, designed to protect jobs and national defense interests. In 1974, the Federal Reserve issued a loan of $1.75 billion to Franklin National Bank, which had lost $63.6 million in the first five months of the year. This bailout averted a banking collapse and protected depositors' savings, showcasing the potential benefits of such interventions. Later, during the financial crisis of the 1970s, New York City received $2.3 billion in loans under the New York City Seasonal Financing Act, signed by President Ford in 1975. This action aimed to ensure that NYC operations could continue while the city navigated bankruptcy.

The financial crisis of 2008 witnessed bailouts on an unprecedented scale. Major financial institutions, including Bear Stearns, Fannie Mae, Freddie Mac, A.I.G., and Citigroup, benefited from substantial government aid totaling hundreds of billions of dollars. The Troubled Asset Relief Program (TARP) was introduced, authorizing the Treasury Department to spend $700 billion on buying distressed assets, injecting capital into banks, and providing aid to the auto industry.

Contemporary Perspective on Bailouts.

The practice of bailouts is contentious, often facing criticism from a free-market standpoint. Critics assert that bailouts create a moral hazard. This refers to a situation where parties are incentivized to take excessive risks, knowing they will not bear the full consequences of failure. This is because bailouts protect financial institutions from the repercussions of their risky decisions, potentially encouraging irresponsible behavior. We have seen evidence of this in the aftermath of the 2008 financial crisis; while banks maintained relative stability, it took only a few deregulation measures in the small-bank sector to prompt community banks to assume tremendous risks, leading to the current SVB crisis. This lack of responsibility in the banking sector stems from the prevalent belief among bankers that the government would never allow banks to collapse; indeed, it did not. Additionally, in industries affected by COVID-19, the US government provided significant aid, propping up airlines to the tune of $50 billion. As evidenced by the current pricing turmoil in the industry, this has done little to preserve the operational capabilities of airlines as was intended. Airlines, like many companies, do not hold additional cash reserves, analogous to "savings" in a personal context, partially because they expect to be rescued by the government during a crisis.

Many critics also argue that bailouts distort the free market, enabling a few central figures to disrupt the natural, decentralized market process of creative destruction. In a free market, businesses that fail are replaced by more efficient and innovative firms. By obstructing this process, bailouts may stifle innovation, hinder economic growth, and magnify management errors by persistently supporting firms that should have failed by any reasonable standard. As highlighted in Milton Friedman's "Capitalism & Freedom":

Any system which gives so much power and so much discretion to a few men that mistakes—excusable or not—can have such far-reaching effects is a bad system. It is a bad system to believers in freedom just because it gives a few men such power without any effective check by the body politic… but it is a bad system even to those who set security higher than freedom. Mistakes, excusable or not, cannot be avoided in a system which disperses responsibility yet gives a few men great power, and which thereby makes important policy actions highly dependent on accidents of personality.

Conversely, proponents of bailouts argue they are necessary to mitigate systemic risk and protect the broader economy. The failure of large companies or financial institutions can cause widespread repercussions, potentially triggering a domino effect of financial instability and economic downturn, and imposing significant financial hardship on employees. From this perspective, bailouts are seen as a necessary evil to prevent a worse outcome: economic collapse. Arguably, both the Great Depression of the 1930s and the more recent Great Recession would have been far more destructive had the government not intervened to alleviate the crisis and stimulate the economy. While critics may scoff at any form of government intervention, the fact remains that letting the economy correct itself—although entirely feasible—is not always practical, as the suffering endured by many employees and more general consumers may be too great a cost.

So, are Bailouts good or bad?

Bailouts, despite their complexity and contentious nature, present both benefits and drawbacks. They can offer a lifeline during economic crises, warding off systemic collapse and preserving jobs. Yet, they may also foster moral hazard, cause market distortions, and disproportionately benefit the affluent and well-connected. The Federal Reserve's current BTFP initiative underscores this delicate equilibrium, with the potential outcomes and impacts necessitating cautious scrutiny as the program evolves. While such programs can function as an emergency tool to manage systemic risk, they may also distort the principles of free markets. The challenge is to strike a balance that encourages economic stability while advocating for accountability and fiscal prudence.

While the effectiveness of the Federal Reserve's current strategy is still under review, one fact remains evident: bailouts are a fundamental part of our economic system. However, our focus should extend beyond devising temporary solutions for economic stability; we need to cultivate an economy—or more precisely, a populous—resilient enough to lessen the need for such interventions. This calls for a more critical examination of the practice of continuous bailouts and whether public money is being used appropriately in such times.

Frequent bailouts can buoy inefficient corporations, fostering a culture of risk without repercussions among the elite, and ultimately robbing future generations of entrepreneurs of opportunities. This promotes long-term economic instability, as funds and resources are consumed in supporting unsustainable companies, harming consumers in the long run more than the fleeting pain of an industry financial crisis.

In our increasingly interconnected global economy, the decisions we make today will influence not only the future of the U.S. financial system but also the global economic landscape. It is crucial that these decisions are informed by a comprehensive understanding of the implications of bailouts, underpinned by a steadfast dedication to long-term economic stability, fairness, and resilience. The road ahead may be replete with uncertainties, but the necessity of navigating it judiciously is indisputable.

We conclude with this quote from The Economist, published a year before the Credit Crisis of 07/08, which arguably resonates more now than it did then:

Part of America's current prosperity is based not on genuine gains in income, nor on high productivity growth, but on borrowing from the future. The words of Ludwig von Mises, an Austrian economist of the early 20th century, nicely sum up the illusion: 'It may sometimes be expedient for a man to heat the stove with his furniture. But he should not delude himself by believing that he has discovered a wonderful new method of heating his premises.'
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