Equity (Page 4)

This is the second part of a three-part series

During the last financial crisis, Carmen Reinhart and Kenneth Rogoff, both now teaching at the Charles River campus of Plagiarism University, wrote an engagingly readable and well-received book, This Time is Different (2009), describing ways in which debt boom and default cycles have varied little since the Middle Ages. 

The most amusing of these similarities is that those who profit most from each such cycle’s bubble phase sustain it by assuring the gullible that this debt bubble, unlike all its predecessors, will not end badly – that this time is different.

Reinhart’s and Rogoff’s warning seems best appreciated as reverse-reprising Tolstoy’s bon mot, in “Anna Karenina”, that although “all happy families are alike, every unhappy family is unhappy in its own way.” 

Although all debt bubbles end unhappily, the happy thoughts used to assure each bubble’s victims that it will not end unhappily must differ enough from the happy thoughts used to sustain recent previous bubbles to seem credible, at least to the gullible.

If a US financial crisis occurs in 2024, it will be novel in certain ways. Of these, the most widely anticipated is that it will occur electronically.  Fear that fast transactions via the Internet and “disinformation” via insufficiently censored electronic media might cause bank runs to spread rapidly have recently troubled elites both in the US and Europe.

Less widely discussed is the possibility that the alienation of customers by the growing electronic automation of financial institutions could aggravate a financial crisis.

During the past decade, bankers and brokers have increasingly hidden from depositors behind websites that often function poorly and phone answering services that often have long wait times and ill-trained staff. This has coincided with the closing of so many branch offices as to give rise to a new financial term, “banking desert,” to describe any of the increasingly numerous and large areas with no physical banking services in which millions of disproportionately lower-income Americans now live.

As an executive of a US-based digital services firm recently observed in discussing the limits of bank automation, having human contact with staff gives a bank’s depositors more confidence in the bank. What might move a depositor to trust bankers who hide from him behind new infotech, and whom he never meets in person? And how can a banking desert dweller tell a failing bank from a bank whose website is dysfunctional or whose phone service wait time is impossibly long? 

It seems not to have occurred to America’s ruling elites that the automation of banking might aggravate a banking crisis in these ways. Perhaps that’s because folks who live in America’s wealthier towns and neighborhoods not only still have branch banks, but increasingly have branch banks newly redesigned to include coffee bars and social lounges.  Only from working-class stiffs do bankers hide behind websites and phone banks.

A more important novel aspect of any 2024 financial crisis is that it will occur after the widely touted but still little-tested replacement of taxpayer-funded bank bailouts by financial industry-funded bank “bail-ins” authorized by Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act, enacted on July 21, 2010, and implemented by Title 12, Part 380, of the Code of Federal Regulations, promulgated on January 25, 2011.

Title II of the Dodd-Frank Act, titled “Orderly Liquidation Authority,” authorizes the Federal Deposit Insurance Corporation (FDIC) to conduct “ball-in” liquidations, funded by the financial sector, of failed or failing banks or bank-like financial firms, in the hope of obviating taxpayer-funded bailouts. 

Title II authorizes the Secretary of the Treasury to put into FDIC receivership, pending liquidation, any bank or bank-like financial firm that is in default or deemed by the Secretary to be in danger of default, and the default of which may endanger general economic stability. 

Title II authorizes the FDIC to use the equity, debt securities or uninsured deposits of the financial firm in receivership, salaries or bonuses recently paid to that firm’s management or directors, or assessments levied on other financial firms, in order to honor that firm’s obligations to its employees and the government, including to the FDIC as insurer of its small depositors. 

The financial assets of the FDIC, which insures deposits of less than $250,000 at US banks, are grossly inadequate to respond to any large financial crisis either by bailouts or by bail-ins. As of June 30, 2023 (the most recent date for which relevant data seem to have been published), the FDIC’s Deposit Insurance Fund (DIF) had a balance of $119 billion. 

The aggregate face value of deposits at US banks was then and is now above $17 trillion. Authoritative data on the total face value of FDIC-insured deposits seem not to be publicly available but diverse observers have recently estimated that slightly more than half of US bank deposits are FDIC-insured. If so, then the FDIC’s contingent liabilities appear to exceed its assets available to cover those liabilities by a factor of at least 70.

Consequently, for the Secretary of the Treasury and the FDIC to respond to any systematic banking crisis in which many US banks default or are at risk of default – or in which even one of the largest US banks defaults or is at risk of default – entails expropriation of private financial assets.

Section 214 of the Dodd-Frank Act reads in full:

• Liquidation required:  All financial companies put into receivership under this subchapter shall be liquidated. No taxpayer funds shall be used to prevent the liquidation of any financial company under this subchapter.

• Recovery of funds:  All funds expended in the liquidation of a financial company under this subchapter shall be recovered from the disposition of assets of such financial company, or shall be the responsibility of the financial sector, through assessments.

• No losses to taxpayers: Taxpayers shall bear no losses from the exercise of any authority under this subchapter.

However, section 206 of the Dodd-Frank Act requires that any action under Title II serve not merely interests specific to the company in receivership, but the stability of the economy as a whole. 

The task of deciding whose assets should be expropriated and whose should not be expropriated in the interest of general economic stability is not an enviable one. No matter how carefully such decisions are made, they may evoke public complaints and considerable resistance from within the far-from-powerless financial industry.

Any financial firm that owns either equity or debt securities issued by another financial firm in FDIC receivership or uninsured deposits in such a financial firm might cite Section 206 of the Dodd-Frank Act to argue that it should be exempted in whole or part from FDIC expropriation of those assets on the ground that their expropriation would increase its own risk of default, thereby imperiling the stability of the whole economy. 

Financial firms might even argue collectively – and plausibly – that the whole financial sector should be subjected to only minimal assessments to fund liquidations under Title II, on the grounds that to extract large assessments from banks in a time of systemically elevated risk of bank default tends further to elevate systematic bank default risk. 

This is particularly true insofar as such assessments increase – as provisions of Title II suggest that they should increase either over time or across firms – with the appraised risk of default by any financial firm from which such assessments are collected.

Any such limitation of assessments could leave the FDIC short of resources to cope with a serious financial crisis, impelling the Executive Branch to ask Congress once again to appropriate funds to bail out rather than to liquidate diverse financial institutions in danger of default. 

Inasmuch as bail-out funds would not be used to implement Title II of the Dodd-Frank Act, their appropriation would not be inconsistent with section 214 of that act, although a return to bailouts rather than bail-ins could effectively render Title II a dead letter.  

The FDIC, in its “orderly liquidation” of Silicon Valley Bank (SVB) and Signature Bank that began in March 2023, declined to use its authority under Title II to expropriate any of those banks’ uninsured deposits to help the FDIC provide insurance to those banks’ FDIC-insured deposits. The FDIC’s decision not to expropriate uninsured deposits generated public complaint.

However, the FDIC’s reason for not expropriating uninsured deposits in SVB and Signature Bank seems self-evident and underscores limitations on the FDIC’s implementation of Title II of the Dodd-Frank Act.

Had the FDIC expropriated uninsured deposits in those banks, then a non-negligible proportion of the nearly half of US bank deposits that are not FDIC-insured might have left the US banking system for some safer haven.  That could have threatened US economic stability by inducing a large and sudden contraction of bank lending, hence of the money supply, and hence of non-financial economic activity.

If, as it seems, the FDIC cannot prudently expropriate uninsured deposits of banks in FDIC receivership pending liquidation, then its resources for making good on its commitment to insure other deposits are limited to its own relatively tiny DIF, the equity and debt securities of the firms in receivership, and assessments levied on other financial firms. 

Nothing guarantees that these resources will prove adequate, in the event of a systematic financial crisis, to obviate the FDIC’s asking the President to ask Congress to appropriate funds for another financial-system bailout like that of October 2008 – especially if the financial industry resists new or increased FDIC assessments.   

Consequently, a third novel aspect of any 2024 financial crisis is that although, as in 2008, it may occasion an urgent demand by the President and Wall Street for another large bailout of the again-insolvent US financial industry, this request may come as a surprise to many voters and Congress members who have been led to suppose that Title II of the Dodd-Frank Act has lastingly obviated such bailouts by authorizing the FDIC to conduct bail-ins.

Thus, if this debt bubble is not different from 2008 in its unhappy ending, it will be different in the happy but untrue reason for which its unhappy ending was unexpected: widespread hope that a large financial sector default crisis could be ended by FDIC expropriation of uninsured deposits in failed banks or of assets of still-solvent financial firms will have been shown to be ill-founded.

So how might the House Republican Congress best respond to a 2024 bailout request? Any US financial crisis in 2024 bad enough to induce President Biden to take the politically perilous action of asking Congress to appropriate funds for another bailout of the US banking system will render Americans more receptive than ever before to novel notions about how such bailouts might lastingly be obviated. 

The 2008 taxpayer bailout of the rich and systematically corrupt US financial elite was so widely and intensely disliked by Americans that it spawned the Dodd-Frank effort to obviate such bailouts in future. If the Dodd-Frank bail-ins fail to obviate another similar bailout only 16 years later, then Americans will be even more desperate to find some way to obviate such bailouts lastingly.

If this session of Congress is asked to appropriate funds for another large financial system bailout, then the Republican Caucus of the House of Representatives, comprising a majority of that chamber’s members, will be particularly desperate for a means of lastingly obviating banking system bailouts. Only by finding some plausible means of doing that can the House Republican Caucus escape from the political dilemma in which it will find itself if this session of Congress is asked for a banking system bailout.

If the House Republican Caucus refuses to appropriate funds for a financial-system bailout needed to mitigate a foreseeably large and rapid incipient economic contraction being precipitated by a financial-sector default crisis, then the preponderance of public blame could shift from the Democrats to the Republicans. In arguing for such blame-shifting, the Democrats would have the overwhelming support of US financial, corporate, academic and media elites.

In addition, one could hardly overstate the temptations that the financial industry can offer to legislators who must fund re-election campaigns in a country where neither campaign contributions nor campaign spending can be restricted because the Supreme Court has ruled that money is speech.

On the other hand, another banking system bailout would be anathema to the increasingly populist and working-class voters who dominate the Republican Party’s primary elections.

Absent some novel and unprecedently persuasive reason to think that this banking system bailout will be the last banking system bailout, populists will oppose it as corporate welfare perpetuating a pseudo-democratic oligarchy that has impoverished American workers for decades in its pursuit of cheap foreign labor by free trade and immigration. 

Moreover, the affections of populist voters, if alienated by the support of another bank bailout, might prove past the power of campaign spending to regain.

Only by conditioning House Republicans’ support for another banking-system bailout on prior implementation of measures that would undoubtedly make that the last banking system bailout could the House Republican Caucus avoid blame for not mitigating an incipient economic contraction without alienating the populist voters who dominate Republican primary elections.

A solution to this dilemma is readily available and seems not only politically expedient but good for everyone in both the short and long terms. It also entails no additional government spending. 

The third and last part of this three-part series will describe that solution, which, although conceptually novel, is easy to understand and is based on widely-accepted financial and institutional economics theory. It is to enable private conversions of banks into a better kind of financial firm that is less prone to default and need no government insurance of its depositors. 

A financial sector made up of such firms, rather than of banks, would suffer fewer financial-system default crises and would not need government bailouts when it does experience such a crisis.

To induce the private sector to replace banks with such better financial firms, the federal government need only eliminate governmental obstacles to profitable private conversions of banks into such firms. The greatest governmental impediment to such conversions is FDIC insurance of bank deposits, which eliminates the greatest profit incentive for such conversions. 

The House Republican Caucus might best respond to any 2024 Biden administration request for a banking-system bailout appropriation by conditioning House approval of such a bailout on prior enactment of legislation of mandating imminent termination of FDIC insurance of bank deposits and of other governmental obstacles to profitable private conversion of banks into less default-prone firms that need no deposit insurance and which, after generally replacing banks, would make the financial system generate fewer default crises and not require government bailouts when such crises occur. 

Ichabod is a former US diplomat.

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