May 21, 2008
Was Bear Stearns Too Big to Fail?—A Commentary by Jonathan Macey ’82
The following commentary was published in The Washington Independent on May 21, 2008.
Was Bear Stearns Too Big to Fail?
Antitrust Laws Required Intervention Long Before the Fed Bail Out
By Jonathan Macey ’82
Sometime during the weekend of March 14-15, the U.S. Federal Reserve decided the government of the United States could not permit the investment bank Bear Stearns to fail. Ben Bernanke, the Fed chairman, told the Senate Banking Committee that the bailout of Bear Stearns was necessary to protect the financial system and, ultimately, the entire economy.
Bear Stearns did not suddenly become an essential component of the U.S. economy the weekend it collapsed. Rather, the regulators at the Fed and the Treasury Dept. and the Security and Exchange Commission either hadn’t notice that Bear Stearns was too big to fail or were incapable or unwilling to do anything about the alleged systemic risks created by companies like Bear Stearns until they failed.
In fact, there are plenty of tools at the regulators' disposal to deal with systemic risk and other catastrophes before a cataclysmic event occurs. In particular, the purpose of the antitrust laws is to promote and protect competition and make sure that no single firm grows so large that it threatens the entire economy.
In a properly regulated economy, there should be robust competition among market participants vying for customers. Firms should not be allowed to become so big, or so politically powerful, that they cannot be allowed to fail. Competent regulators break up monopolies and trusts that threaten to distort and undermine markets. They should do the same to firms that become too big to fail, too interconnected to fail or too anything else to fail.
One can only wonder why nobody at the Fed or the Treasury Department or the SEC noticed that Bear Stearns was too important to be allowed to fail before March 14. More important, now that Bear Stearns has been gobbled up at taxpayer expense by JP Morgan, is anyone from the massive U.S. financial services regulatory bureaucracy drawing up a list of what other banks and investment firms are too big too fail, so action can be taken sooner rather than later?
In other words, the Bear Stearns bailout is proof positive that the government has not been doing its job in regulating the financial services industry. Worse, the government's actions since the bailout indicate that the government is still not doing its job to protect the public against the specter of systemic financial risk.
Government regulators remain in a purely reactive posture. Officials at the Fed, the SEC, the Treasury and other agencies simply wait for financial institutions to implode. Only then do they decide whether the collapsing financial institution is, like Bear Stearns, too important to fail, or whether it should, like other businesses, be subject to market forces. It is strange that U.S. regulators do not even appear to acknowledge that there is any other approach.
This waiting game is deplorable public policy. Reasonable people disagree about whether Bear Stearns was too big to fail. Many say it was not. But others offer a new bit of jargon: Bear Stearns was "too 'interconnected' to fail." This is the word de jour many academics and bureaucrats use to emphasize that Bear Stearns was a trading firm that had massive numbers of trades with many different counter-parties, and it would be annoying and expensive for these counter-parties if Bear Stearns failed. This is the same discredited argument that FDIC regulators used to justify the bailout of Continental Illinois in 1984.
But suppose it were true that allowing Bear Stearns to fail would have somehow caused the entire U.S. economy -- or global economy -- to tank. Then regulators should have figured this out before, not after. The reason we have the comprehensive federal deposit insurance scheme is to protect certain "counter-parties" known to most of us as "depositors," with exotic investments like "checking accounts" or "savings accounts," from suffering if their banks go under.
But banks pay for this deposit insurance, and the deposit insurance program is managed so it does not metastasize into a corporate welfare system that protects all bank counter-parties. When the Fed bailed out Bear Stearns, however, it didn't have a clear set of marching orders from Congress like the Federal Deposit Insurance Act and its progeny. In fact, the Fed didn't even have a plan. They acted on instinct in a moment of panic -- hardly conducive to the formulation of sound regulatory policy.
So the government is now in the business of insuring investment banks as well as commercial banks -- one it should not be in. If investment banks are really too big, or too "interconnected," to fail, then the antitrust laws should be deployed to fix the situation by breaking them up. Barring that, the government should, at a minimum, organize the same sort of coherent system for dealing with investment bank failures that it has for commercial bank failures.
As a result of the Bear Stearns bailout, there is an imbalance between the treatment of commercial banks and investment banks. This discrepancy is one thing that makes this a transformative event. The Fed has fundamentally altered the role of the central bank in a free market economy. And it has done so in a way that creates profound distortions in the capital markets and in the traditional relationships among financial institutions.
When the Fed bailed out Bear Stearns, it determined, for reasons known only to itself, that it would protect the multimillion dollar hedge fund and investment banking counter-parties of Bear Stearns rather than the $110,000 payroll account of the corner pizzeria or convenience store.
The federal deposit insurance scheme operated successfully for almost 80 years, from 1929 until 2008, when the Fed upset this regulatory equilibrium by extending the protections to all creditors – even the largest creditors – of big investment banks.
But the reason deposit insurance is limited to relatively small deposits is simple: Big depositors can fend for themselves. In addition, because big deposits are uninsured, sophisticated big depositors carefully monitor excessive risk-taking by their banks. This, in turn, helps all depositors by decreasing bank risk and controlling what economists call "moral hazard" -- a fancy term for the proclivity of people with insurance protection to take more risks than people without insurance.
Before we decided to extend deposit insurance protection beyond commercial banks to the investment banking industry, we should have decided if it makes any sense. It doesn't. Moreover, even if it did, why require banks to pay for federal protection while giving it away for free to giant investment banks like Bear Stearns?
The basic justification for deposit insurance is to protect society against the collective action problem that makes banks highly unstable and particularly susceptible to runs and panics. Banks' liabilities are held in the form of short-term or relatively short-term demand deposits or certificates of deposit. In contrast, banks' assets tend to be medium- to long-term in duration. Also, banks liabilities (deposits) are easy to value. Everyone knows how much their bank owes them. On the other hand, banks' assets (loans) are illiquid and opaque, making them difficult to value.
These intrinsic characteristics of banks cause instability in the financial system. Bank depositors face a collective action problem known as the "prisoners' dilemma." The best strategy for depositors as a group is to refrain from withdrawing their funds precipitously, and to base withdrawal decisions not on what other depositors do, but on their own, independent wants and desires.
By contrast, the safest strategy for each depositor as an individual is to withdraw their funds the moment they hear the slightest rumor of financial weakness within the bank, or even unusual activity among depositors. This is because no bank can meet the liquidity needs of all of its depositors at once.
Banks, in the absence of a creditable deposit insurance regime, are unstable creatures. That is why even the most free-market theorists, like the University of Chicago's Milton Friedman, have favored federally sponsored deposit insurance plans, at least as an option for banks and depositors. Access to the so-called discount window -- the low interest rate loans from the Fed -- serves the same purpose, to protect banks from panics.
In other words, the thing that makes banks truly unstable, at least in the absence of deposit insurance, is that banks' depositors have access to banks' liquidity on a first-come, first-served basis. This means if depositors experience an unexpectedly large demand for liquidity, banks will encounter a "run," as depositors try to protect themselves by cashing in.
The government-sponsored deposit insurance, however, creates a legitimate demand for massive government regulation, because once the government enters the business of offering deposit insurance, it must take steps to limit its liability.
Friedman's core idea was that government regulation of some kind was necessary to prevent bank failure. Regulation could take the form of deposit insurance, which operates before the fact, to prevent bank runs and panics, or it could operate ex post, by using monetary policy orchestrated by the central bank to inject money into the system and provide liquidity.
In "Monetary History of the United States," Friedman and his co-author Anna Schwartz observe that the Federal Reserve failed to do its job during the banking crisis that followed the stock market crash in 1929. They argued that the Fed permitted a collapse of the monetary system by allowing sound banks to fail by the thousands because of liquidity problems -- despite the fact that the Fed had been set up in 1913 to prevent this very thing. Friedman and Schwartz argue that, because the Fed had failed in its responsibilities "something else was needed to perform the function for which it had originally been established and…the Federal Deposit Insurance Corporation would serve that function."
As Friedman pointed out, the deposit insurance system worked for more than 40 years. From 1934 until the early '70s, there were few bank failures. And there were essentially no runs on banks because of liquidity problems.
Unlike commercial banks, investment banks like Bear Stearns are not financed with deposits available on demand. Investment banks are not inherently unstable. They are not uniquely susceptible to runs and panics. Moreover, U.S. commercial banks are among the most heavily regulated businesses in the world. This regulatory scheme has been put in place to reduce risk and mitigate the moral hazard associated with government-sponsored deposit insurance.
For example, commercial banks are subject to: entry restrictions on who qualifies for insurance; strict guidelines on capital maintenance; guidelines on distributions of free cash flow; restrictions on the scope of activities; regulation of management quality; regulation of investment policy; regulations requiring diversification of investments; rights of regulators to information and to enter the premises and examine financial records and other documents.
The Fed's bailout of Bear Stearns has created a grave injustice. Commercial banks have to pay for the government protections that the Fed now appears willing to extend to commercial banks for free. Worse, investment banks appear to have access to the government's protection without having to comply with the prudential regulation designed to protect the government from excessive risk-taking proclivities of insured financial institutions.
Jonathan Macey is the Sam Harris Professor of Corporate Law, Corporate Finance & Securities Law at Yale Law School.