End the Bailout Culture

Ross Levine >> Today, policymakers look to roll back financial regulations, hoping to drive up entrepreneurship, boost economic growth, and increase wages. But without an end to repeated bailouts, the country's financial system risks a crisis on a scale that could ultimately dwarf that of 2008's Great Recession.

For over 40 years, U.S. authorities have repeatedly bailed out failing banks and other financial institutions, creating an increasingly fragile System.

During the 2008 financial crisis, banks like Citibank and Bank of America, financial institutions like AIG and Goldman Sachs, and mortgage companies like Fannie Mae and Freddie Mac were deemed too big to fail.

U.S. authorities stepped in to keep those entities from going under with cash infusions or relief programs.

These policies incentivize financial institutions to engage in excessively risky behaviors, knowing full well that the US Authorities will be there to rescue them if their gambles fail to pay off.

High-risk, high-reward strategies can lead to large payouts for the banks when those investments succeed. When they don't, banks can sidestep the consequences.

The government keeps them afloat and shifts the losses to the taxpayers. Heads - the banks win. Tails - you lose.

When financial institutions do not expect government bailouts, investors and decision makers reap the rewards from successful investments, but also shoulder the consequences when investments fail. In a healthy financial system, decision makers have skin in the game.

It is the possibility of failure that constrains excessive risk-taking and encourages more prudent decision-making.

The Dodd-Frank Act of 2010 was meant to prevent future crises like that of 2008. However, the 2,300-page piece of legislation is burdensome and complicated for banks to follow.

Those costly regulations have induced bank lending to small businesses to fall and caused the disappearance of numerous small banks.

Worst of all, it cemented and codified the Federal Reserve as financially responsible to institutions deemed systemically important and therefore too big to fail, exemplified most recently when Silicon Valley Bank collapsed in March 2023, and federal regulators even protected large, sophisticated uninsured depositors.

This ongoing bailout pattern has created a deeply entrenched bailout culture in the United States.

Deregulation may solve some of the problems created by the Dodd-Frank Act by eliminating some of the costly regulatory apparatus, which creates barriers to entry, impedes efficient allocation of credit, and slows economic growth.

But rolling back regulatory constraints on excessive risk-taking without eliminating the expectation of bailouts that incentivize it only exacerbates the problem.

What can be done? Credibility is key. Regulators and policymakers cannot merely promise to end bailouts because they have repeatedly shown they will bail out banks if investors don't think they have skin in the game, they will continue adopting high-risk investment strategies.

One option is to require banks to fund themselves more with equity and less by borrowing from depositors and others, forcing shareholders to absorb greater losses before taxpayer money, and it is even an option.

Another option is to force banks to borrow from larger investors who the government could credibly commit to, not bailout. Such investors would have the incentive and ability to constrain excessive risk-taking.

Finally, clawback provisions, which compel executives to surrender past earnings should their institutions fail, create a powerful incentive for prudence by forcing decision makers to have more skin in the game.

Reducing the regulatory burdens of Dodd-Frank can foster growth if implemented correctly. But the sequence in reform is critical.

It's easy to slash regulations. It's difficult to implement policy reforms. To fix the perverse incentive system, it is essential to end the bailout culture first.