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Washington Recaptured

WASHINGTON, DC – Two hundred years ago, Washington DC was captured by the British – who then proceeded to set fire to official buildings, including the White House, Treasury Department, and Congress. Today, it is a domestic interest group – very large banks – that has captured Washington. The costs are likely to be far higher than they were in 1814.

America’s largest bank holding companies receive an implicit government subsidy, because they are perceived to be “too big to fail.” The authorities will not allow the biggest banks to default on their debts, through bankruptcy or in any other fashion, owing to the need to prevent the financial system from collapsing. This doctrine became starkly apparent in late 2008 and early 2009; it remains in force today.

This effective exemption from the risk of bankruptcy means that anyone who lends to the largest half-dozen banks receives a government guarantee – free insurance against the risk of a catastrophe. This allows these banks to obtain more debt financing on better terms (from their perspective). In particular, their executives operate highly opaque firms, with risks effectively masked from outsiders and very little in the way of loss-absorbing shareholder equity. Simply put, without their government backstop, these murky empires could not exist.

Democratic Senator Sherrod Brown of Ohio and Republican Senator David Vitter of Louisiana, along with some important colleagues, have long sought to phase out this implicit subsidy. And independent analysts, such as Anat Admati of Stanford University, have explained all of the relevant details of how – and why – this should be done. Those details – for example, in Admati’s recent testimony to the Senate subcommittee chaired by Brown – are not in doubt. Thanks to Admati and her colleagues, we have a clear rendering of them in straightforward, non-technical language.

Unfortunately, the leading federal government officials remain in denial. The most spectacular recent example of this is a report issued this summer by the Government Accountability Office. The GAO had a simple task: At the request of Brown and Vitter, it was charged with assessing the scale and impact of the implicit guarantees provided by the government to large bank holding companies.

The GAO responded by producing a deeply muddled report that followed the financial industry’s suggestion of focusing almost exclusively on the difference in bond spreads (interest rates on various forms of financing) between the largest banks and some of their competitors. Such spreads are only a small component of the funding advantage for big banks, and they are also highly cyclical – meaning that the advantage for the biggest banks manifests itself the most when markets are under pressure, as they were in the fall of 2008.

The GAO concluded that these spreads had indeed been high in 2008, and that now they have fallen. But, as Admati pointed out in her testimony, if the authors had included 2006 and earlier years in their analysis, they would have seen low spreads using their own methodology – despite the obvious fact that massive implicit subsidies were already in place. All that the GAO established is that the macroeconomy was previously in bad shape and it is now doing somewhat better – hardly a profound finding.

The GAO report also refers to the Dodd-Frank financial reforms of 2010, including the requirement that large bank holding companies create “living wills.” The industry contends that the existence of these living wills – showing how a big bank’s collapse could be handled without causing global financial panic – means that “too big to fail” is over.

Sadly for the GAO, shortly after their report appeared, the Federal Reserve and the Federal Deposit Insurance Corporation rejected the most recent living wills as completely inadequate – meaning that there is still no road map for handling the failure of a very large bank. Either such a firm would be allowed to fail, with dire consequences for global finance, or there would be some sort of backdoor bailout.

The GAO’s failure to see and state this problem clearly is a major disappointment. As FDIC Vice Chairman Tom Hoenig put it, “Despite the thousands of pages of material these firms submitted, the plans provide no credible or clear path through bankruptcy that doesn’t require unrealistic assumptions and direct or indirect public support.”

To be fair, the GAO is not the only part of official Washington seemingly beguiled by large banks. While the Fed now recognizes that living wills are inadequate, it has taken an extraordinarily long time to reach this rather obvious conclusion – and the Fed’s Board of Governors is still dragging its feet on forcing the banks to simplify their operations.

American forces performed disastrously at the Battle of Bladensburg in August 1814, allowing the British to capture and burn the capital. Two hundred years later, we may well be witnessing that battle’s intellectual and policymaking analogue.

Simon Johnson is a professor at MIT’s Sloan School of Management and the co-author of White House Burning: The Founding Fathers, Our National Debt, And Why It Matters To You.

Copyright: Project Syndicate, 2014.

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