Fed Chairman Ben Bernanke testified before the Senate Banking Committee today. While much of what he was asked about related to monetary policy, the sequester and such issues, he was also asked a number of questions about financial reform and Wall Street’s too-big-to-fail firms and activities. No doubt that his exchange with Democratic Senator Warren and Republican Senator Vitter on these topics will get lots of attention, as they should.
We will address a number of those issues later. However, for now, we wanted to address one ongoing, overriding issue: government and taxpayer support for Wall Street’s too-big-to-fail firms and activities, which provides them with unfair and unjustified subsidies.
Almost everyone refers to these subsidies as “implicit.” They are usually referring to the funding advantage Wall Street’s too-big-to-fail firms, which get to borrow at lower rates because they are viewed as having less risk because the government won’t allow them to fail, i.e., investors are more likely to get their money back. That funding advantage is a subsidy which also allows them to compete unfairly against others who have to pay more to borrow money because they are not too big to fail and therefore have more credit risk. Thus, this unfair competition is not only enabled by government support, but arises entirely from that government support.
Before Wall Street caused the financial crisis in 2009-2009, this was largely implicit. That is, most people believed that the gigantic firms on Wall Street were so big and, therefore, interconnected with the entire US and often global financial system that the failure of any one of those firms (or activities like money market funds) would likely cause the entire financial system to collapse. Before 2008, this used to be an assumption based on strong beliefs and evidence: if a big firm failed, the US government would bail them out. There was the bailout of the Continental Illinois Bank in 1982 and the government brokered bailout of the hedge fund Long Term Capital Management in 1998 and a few other examples of varying sizes and degrees along the way.
But the world changed forever in 2008-2009: the previous belief that the US government and taxpayers would come to the rescue and bailout Wall Street’s too-big-to-fail firms and activities became a reality. The only reason Wall Street’s reckless and almost certainly criminal trading and investments didn’t collapse the entire global financial system is because the US government and taxpayers pumped literally trillions of dollars into the financial system to prevent it’s total collapse.
Thus what was an implicit assumption before 2008 that Wall Street’s gigantic firms and activities were too big to fail or, more accurately, allowed to get so big that the government couldn’t afford to allow them to fail became explicit. Indeed, it became the announced policy of the federal government, as we have detailed elsewhere.
That remains the policy of the US government today, even though many like to deny it. That willingness to put taxpayer money behind Wall Street’s too big to fail firms and activities is the only thing that makes their credit risk lower which is what gives them the funding and competitive advantage. Indeed, without government backing, their credit risk should be quite high and, therefore, their funding costs should be high, putting them at a competitive disadvantage and probably putting them out of business as a result, at least in their current form. (The fact they are all — maybe all but 1 — trade below book is another perspective supporting this likely outcome.)
That’s what people are talking about when they talk about the “implicit” subsidy to Wall Street’s too big to fail firms and activities. However, there seems to be a pretty good argument that the subsidies are explicit . But, however labeled, they are unjustified, unfair and indefensible. That should be the accepted premise and should be the fuel for ending them, which Chairman Bernanke didn’t seem to be on board with.