Richard Vague was co-founder and former CEO of First USA Bank and former CEO of Juniper Financial. He also publishes Delancey Place. Richard Vague recently spoke at the New America Foundation on the connection between the Iraq War, high oil prices, and what was happening to the US. economically. Here is a shorter clip.
Over the last several months, and especially the last few days, we have seen the Federal Government intervene in unprecedented ways to rescue or help rescue some of the largest financial institutions in our nation. This intervention has been unpredictable and has taken several different forms. The government has acted to save certain institutions–Fannie Mae, Freddie Mac and AIG. It has assisted in arranging a takeover–Bear Stearns. And it has walked away from Lehman and allowed it to fail.
In some cases it has tried to preserve some value for existing shareholders or managers, in others not. While the government officials involved have outlined some guiding principles, their actions seem to indicate that the government is improvising rather than acting from any firm set of guideposts.
I’ll let others more familiar with the details debate whether the specific structures of the above-mentioned rescues were appropriate. What I’d like to discuss instead is whether in general it is good policy for our government to intervene to rescue businesses, or whether instead government should stand aside and let each of these institutions fail. My answer will lie somewhere in between.
I subscribe to the view that most bailouts of businesses are unnecessary and bad policy.
Many applauded when the government bailed out Chrysler in 1979, but since that time, U.S. automakers’ share of world markets has declined from almost 80% to 45%, causing some to argue that the comfort of the bailout allowed GM and Ford to avoid the hard decisions that would have allowed them to truly compete at the level of a Toyota. And the propped-up Chrysler has remained a sickly also-ran even to this day.
But in a market nosedive, financial institutions and the liquidity they provide serve a unique and crucial role. This can be illustrated by the widely-remembered failure of Bank of United States during the Great Depression. It was allowed to fail, setting off a nationwide run on banks.
A key consequence was that many of its borrowing customers, small businesses that required working loans to operate, lost their loans from the Bank of United States and therefore failed too–even though they were solvent and ran credit-worthy businesses. For every one dollar of capital that a bank has, it can make about ten dollars in loans–with a multiplying effect on lending that is inherent to banking. But when a bank fails, and in the resulting chaos some of its loans to customers are curtailed, called or cut-off, this multiplying effect works in reverse and jobs and business activity can dramatically contract.
Financial institutions can fail even when they are profitable and have adequate capital–if they lose their own funding, either through a “run” on their deposits or if their own lenders call or do not renew their loans to that institution. In these cases, a lender of last resort can rescue that financial institution simply by supplying the missing funding until it can be restored. In this type of case, the consequence of failure on business activity are of course the same.
So rescuing lending institutions is critical. But my view is that the critical part of these institutions to preserve is the loans and other credit extended to worthy borrowers. And just because you are rescuing that part of a financial institution, it does not follow that you also have to rescue the shareholders of that institution or the senior management of that institution. Where the rescue is necessitated because of losses I would argue that you don’t. And it does not mean that in due time you cannot sell or auction off the assets or components of that failed institution to other, stronger institutions. Where the rescue is necessitated because of losses I would argue that you should. But in today’s world, with very complex lending instruments and derivatives thereof, it requires careful administration to make sure that credit is not inappropriately contracted so as to further damage the economy. And that takes the time that a rescue can deliver.
In the periodic financial crises that have occurred in the U.S. and Europe since the onset of the industrial age, damage has been more successfully contained and recovery has come more quickly when there has been a large institution or institutions to step in and provide liquidity to prevent financial institution failures and “runs.” Institutions that have played that role in the past have included the quasi-governmental Bank of London, the old JP Morgan Bank, the New York Clearing House banks acting in concert, and more recently, the U.S. Federal Reserve Bank.
Where the leading institutions have not decisively played that role during a panic, consequences have been severe–the best example being the Great Depression itself.
— Richard Vague