Holman Jenkins, the prolific and provocative opinion writer for the Wall Street Journal, has been writing lately that the entire bank bailout mess could have been avoided had our bank regulators, the Paulson Treasury and the Bernanke Fed, decided to forbear from enforcing bank capital standards for troubled banks. By looking the other way at the mounting bank losses, but still guaranteeing bank deposits to prevent a run, policy makers could have avoided asking Congress for the $700 billion in TARP monies. We then could avoided the large (but presumably temporary) bump up in the deficit (putting aside the bump due to the stimulus package), while Members of Congress in both parties need not have angered the public with lots of bailout talk (though there still would have been some of that with the federal rescues of AIG, the housing GSEs, and the auto companies).
This is a line of argument that should be taken seriously – although more for historical purposes than anything else. Given the creation of the TARP and widespread acknowledgement now of the need for more transparency and appropriate asset valuation on bank balance sheets, it is too late to implement anything like what Jenkins recommends.
Nonetheless, it must be acknowledged that there is ample precedent in our recent history for his recommended approach. In the 1980s, our bank regulators did not force the money center banks to mark their LDC loans anywhere close to market, which very likely could have pushed many or even all of them into insolvency – and thus government ownership, as happened with Continental Illinois (which was not re-privatized until the early 1990s). By letting these banks stay in business, policymakers essentially gambled on their resurrection, which indeed happened as the economy later recovered.
The overwhelming consensus of policy makers and financial policy specialists at the time, however, was that we were lucky with this episode of regulatory forbearance, and that it should be not repeated. The problem with forbearance is that when it is combined with deposit insurance, banks that gamble for resurrection can dig themselves – and thus potentially taxpayers – into deeper graves. Indeed, some of the money centers did exactly that, using the breathing room they were given by regulators to make what turned out to be bad commercial real estate loans and loans to support leveraged buyouts. The savings and loans were much worse, gambling away roughly $150 billion in new losses that eventually had to be absorbed by taxpayers. I know $150 billion looks cheap by today’s bailout standards, but trust me as one who commented on that experience at the time, most people then thought $150 billion was a lot of money.
To keep all this from happening again, Congress passed a law in 1991 requiring regulators to take “prompt corrective action” to cure capital shortfalls in banks. This means that as a bank’s capital dwindles below the regulatory minimum, its activities are subject to an increasingly stiff regulatory regime, including suspension of dividends, salary restrictions, and a mandate to raise more capital. If all else fails, bank regulators are required to take control of the bank just short of insolvency (when capital falls to less than 2% of assets), and either operate it, sell it to other banks or investors, or liquidate, whichever is the least cost way of handling the situation.
In advocating forbearance this time around, Jenkins is essentially arguing that regulators should have effectively ignored the 1991 law (called by its acronym, FDICIA) and operated the way they did in the 1980s. But to be fair to Jenkins, presumably he would have had the regulators also clamping down on the banks’ further risk-taking – in other words, keeping them in business, but marking time until the economic recovery enabled them to make enough money to restore their capital positions (Maybe he would have had the regulators encouraging the banks to raise more capital, too, but this would have been a public acknowledgement of the banks’ weakness, something that presumably Jenkins would not want to have happened). And, although I presume Jenkins would not endorse the idea, if the Treasury back in the fall instead had backed a large publicly funded plan to help troubled homeowners – roughly the size of what President Obama has now proposed, though not necessarily with the same details – then this would have reduced the banks’ losses, and thus would have reduced the amount of forbearance that regulators would have to give.
Could have all this worked – and avoided the mess we are now in? One objection is that the U.S. couldn’t have pulled it off given all of the criticism we had leveled against Japan for practicing forbearance in the 1990s. Again and again our policy makers told Japan to face the music, and spend whatever it took and quickly to clean up its banks’ balance sheets. With the shoe on the other foot, and the whole world watching, could U.S. regulators, our Treasury Secretary and our Fed Chairman have faced the public and Wall Street and effectively have said either that the banks were really solvent on a long-term basis, or that if they weren’t it needn’t have mattered? I doubt it, but am certainly open to hearing a counter-argument.
Then there is the problem of the frozen inter-bank lending market in September, especially after Washington chose not to rescue Lehman. Had regulators openly practiced forbearance, rather than poured TARP money into the breach, would interbank lending rates have come down? Here, Jenkins has a plausible answer: the Fed could simply have guaranteed all inter-bank loans, and this would have had the same calming effect, but without the immediate expenditure of funds. To be sure, guarantees have moral hazard effects, but presumably regulators could have clamped down on bank lending to constrain it.
But this brings us to a third objection to the forbearance idea: that, to prevent a rerun of the gambling for resurrection we saw in the thrift crisis of the 1980s but with more zeros at the end, regulators would have had to tighten their oversight of bank lending. This would have resulted in the same outcome we have now – with seemingly everyone beating on the banks to loan more money, but unable to do so because of regulatory limitations, or because of fears by bank management of lending more during a sharply deteriorating economy.
Jenkins’ come-back to this is that even with this same dismal outcome we still wouldn’t have shelled out $700B and thus avoided the messy and increasingly politicized debate over the bank bailout. But I suspect we still would then have had a different debate over “where are the regulators?” I also suspect that historians and economists will be arguing about all this for years to come. Jenkins’ provocative thesis may at some point become a central topic in this debate.
