How Government Props Up Big Finance

The financial industry has grown large on the backs of government handouts, manipulated regulation, and taxpayer bailouts

Since medieval times, writers and ethicists have counted envy among the seven deadly sins. In utilitarian terms, envy is at best a zero-sum game because it can only be satisfied when someone loses.

Given this moral and practical failing, it is a shame that envy plays such a large role in the Occupy Wall Street protests spread around the country. And, yet, the Occupy movement does have a point that transcends this negative emotion: the financial industry has grown large on the backs of government handouts, manipulated regulation, and taxpayer bailouts.

While there is no objective size the financial industry should be, it is fair to say it would never have become this large without the crony capitalist system that has masqueraded as a free market. In the process, the financial industry has absorbed resources that could better be used elsewhere while imposing large, systemic risks on the economy. Watching others grow rich from special privilege understandably leads to envy, but from this perspective, the high compensation received by financial industry leaders is merely a symptom of a much larger problem.

Big finance has achieved its present girth on the back of numerous policy decisions – some going back centuries. Many of these policies had the intention of protecting the general public, but often had the unintended consequence of enriching bankers beyond the product of their labor.

For example, central banks often seek to encourage growth by lowering interest rates for small businesses and individuals. But in the process it is mainly large banks that benefit from higher margins, as the Fed provides lendable funds at a steep discount – not all of which is shared with borrowers. Federal policies designed to assist homebuyers also benefit mortgage investors and grant them taxpayer supported guarantees they will get paid (bailing out Fannie Mae and Freddie Mac has already cost $182 billion as a result).

Subsidized mortgages also result in higher home prices – undermining affordability goals. Over the long term, consumers become more leveraged, while financial firms collect more interest and fees.

But special privileges to the financial industry predate discretionary monetary policy and subsidized lending. Indeed, these privileges are so embedded in our system, they never occur to us. Perhaps the most distortionary of these is banking licenses that offer limited liability. Without such licenses, bank owners would have to use their personal assets to redeem deposits if borrowers default. Limited liability reduces the bank owners’ risk to just their initial investment. The large number of state banking licenses granted during the nineteenth century allowed “one-percenters” of that era to profit from borrowing and lending, without worrying about large losses. They could also grow their institutions by making loans to less creditworthy borrowers, thereby creating systemic risk.

This risk was usually shouldered by depositors, who often lost money during bank runs. During the Depression, the federal government solved this problem by creating deposit insurance. FDIC insurance enabled banks to grow even more, and it also freed them to take on even greater risks, since depositors no longer worried about how their funds were being deployed.

As financial institutions have grown and consolidated over the years, some have become so systematically important that they have been deemed too big to fail. These institutions are now effectively eligible for bailouts in which all creditors – and not just small depositors – are made whole while management can either remain in place, or walk away with all their previous compensation plus a severance package to boot.

These protections and hidden subsidies have enabled the financial industry to achieve enormous size and profitability, while placing the overall economy at great risk. Usually, these protections were accompanied by regulations such as capital requirements or size restrictions. These regulations usually failed to achieve their intended results – especially over the long term – because financial institutions are able to wear down the restrictions by lobbying and by hiring away key regulators.

Instead of adding to the quantity of regulation, thereby creating more opportunities for the financial industry to game the system, we should tame the financial beast through greater accountability. One way to do this is to add a 10 percent co-insurance feature to FDIC insurance for deposits above $10,000. Depositors with $11,000 in a failed bank would receive $10,900; while those with a $250,000 balance would get $226,000.

Depositors would not be wiped out in the event of a failure, but they would have an incentive to select banks that are more careful with their money (while the poorest are still fully protected). Banks would then have to compete for depositor business, in part, by demonstrating that they have strong risk management.

Those with exposure above the FDIC limit should take at least a 25 percent haircut through the resolution process in the event of a bank failure. These stakeholders are often large financial institutions, acting as counterparties, who have the skill and resources to more closely monitor the banks with which they deal. This reform would address one of the most disturbing episodes of the financial crisis: Goldman Sachs’ full recovery on CDO insurance contracts that triggered the AIG bailout. Certainly low and middle income taxpayers had better uses for this money than awarding it to the highly compensated financial wizards at Goldman.

Bank managers should also have more skin in the game. If a bank fails or receives a bailout, directors, senior managers and highly compensated employees should have to repay creditors or the government at least a portion of past compensation they received from their failed institutions – particularly compensation tied to performance. Fear of impoverishment would have a substantial impact on the risk appetites for those leading major financial institutions.

Finally, federally subsidized or guaranteed loans should be restricted to the truly needy. Today, mortgages of up to $625,500 can be purchased by Fannie Mae and Freddie Mac on the federal government’s credit card. This subsidy should be limited to homes that are below the median price for a given area. If financial industry players want to originate mortgages to members of the upper middle class, they should be willing to assume the full risk of providing these loans.

Indiscriminately taxing the rich is an envy-driven policy that only marginally addresses Wall Street’s size, profitability and systemic risk. Vindication should always be discarded in favor of an effective reprieve. Policies that require financial industry participants to shoulder more of the risks they create will reduce the burden Wall Street imposes on the general public, will shrink the industry, and will release human talent for higher and better purposes.

Rather than demotivate the next Steve Jobs, or reduce the resources Bill Gates deploys to fight AIDS and malaria, let’s instead focus the Occupiers’ energy on advocating solutions that truly improve the lives of the 99 percent.

This article was originally published at RealClearMarkets on November 22, 2011.