Too Big to Fail

(page 2 of 2)

Browse Issues

Browse the BusinessWeek Archive

If a major bank slips into deep trouble, Uncle Sam may have to help save it Scott Menchin

Story Tools

• post a comment
• e-mail this story
• print this story
• order a reprint
• digg this
• save to del.icio.us

During the savings and loan crisis in the 1980s, critics lambasted the government for not supervising the banks properly in the first place and then for passing out aid to the ones headed by politically well-connected individuals. Central bankers face a dilemma, says veteran economist Henry Kaufman of consulting firm Henry Kaufman & Co., in choosing whether to save the day or enforce financial discipline.

Of course, the threat of a big bank failure today may subside. The government's latest rate cuts and additional spending programs may boost the economy and banks' balance sheets. And banks already are replenishing their coffers with more than $20 billion from sovereign wealth funds.

"AGGRESSIVE POLICY RESPONSE"

But the high cost of oil, the weak dollar, and falling house prices continue to cloud the outlook. And hot spots are flaring that could worsen the crisis. Bond insurers, for example, are taking huge hits on subprime exposure. One risk is that the insurers' woes will spill over into the municipal bond market, since state and local governments depend on insurers to back the bonds they issue for roads and other projects. Any success New York regulators have in attracting capital to the bond-insurance industry would help solve the muni problem and limit the need for a government-funded bailout. "There needs to be an aggressive response," says Christian Stracke, a senior analyst at research service CreditSights. "It is very urgent."

The government's take on bailouts has evolved over the years. The public decried Washington's intervention in the 1980s, a period marked by hundreds of rescues of savings and loans that liberally spread government largesse. So in 1991, Congress passed a law stipulating that broken banks could be fixed only at the "least cost" to taxpayers, generally by covering only insured deposits of up to $100,000.

But the law gave regulators a loophole. It allows bigger bailouts if top officials, in consultation with the President, decide they are necessary to prop up the financial system. That clause has yet to be tested. But then again, no big banks have failed in the 16 years since the law was passed.

Regulators have also increased scrutiny of the biggest financial firms, reducing chances of a bailout. The Fed, for instance, runs computer simulations of failures to determine which banks perform certain critical functions in the financial system. After such an analysis two years ago, the Fed sanctioned procedures to launch a cooperative bank quickly in the event that JPMorgan Chase (JPM) or Bank of New York, the two leaders in clearing trades of U.S. bonds, ran into trouble.

The Federal Deposit Insurance Corp., meanwhile, has tuned up its procedures so it can quickly make good on insured deposits. FDIC Chairman Sheila C. Bair said in a speech before the problems surfaced that, as result of all the changes, she "would be hard-pressed to envision a scenario" in which the government grants significant bailouts to a wider pool of creditors and investors.

Still, a new round of bailouts would likely breed more. Gary H. Stern, president of the Federal Reserve Bank of Minneapolis and author of Too Big to Fail: The Hazards of Bank Bailouts, says that the seeds of today's woes may well have taken root during previous interventions. He believes the banks would have curbed some of their bad lending practices and risky subprime investment decisions if they didn't have implicit guarantees of a government safety net. It's not unlike what Federal Reserve Chairman Ben S. Bernanke said about bailouts back in April when he pronounced that bank investors "must be...persuaded that they will experience significant losses in the event of failure." Otherwise, he said, it's all too easy for bank executives to waste money on bad loans.

But the tough-love approach, concedes Stern, can only be used during periods of stability: "When you're dealing with financial turbulence, you've got to deal with the problem at hand."