House of Debt by Atif Mian & Amir Sufi

Author:Atif Mian & Amir Sufi [Mian, Atif]
Language: eng
Format: epub
ISBN: 9780226277509
Publisher: The University of Chicago Press
Published: 2015-04-20T00:00:00+00:00

Resuming the Flow of Credit

Support for the banks in the United States during the Great Recession went far beyond protecting the payment system. Indeed, government policies took money from taxpayers and gave it directly to the creditors and shareholders. Pietro Veronesi and Luigi Zingales estimated that the equity injections into large financial institutions by the Treasury in the fall of 2008 increased the value of bank debt and equity by $130 billion.12 Bryan Kelly, Hanno Lustig, and Stijn Van Nieuwerburgh examined options on bank stocks and indices, and found that “a collective government guarantee for the financial sector” helped significantly boost the price of bank equity.13 So while any policy that would have helped home owners was shelved, governments bailed out bank creditors and shareholders using taxpayer money. Why?

President George W. Bush explained the reasoning explicitly in his September 24, 2008, speech to the nation.14 It was an impassioned plea to pass the bank bailout legislation, which he assured would “free up banks to resume the flow of credit to American families and businesses, and this will help our economy grow.” The banking view goes beyond protecting depositors and the payment system. It argues that bank creditors and shareholders must be protected in order to ensure that banks continue to lend.

If this sounds like a strange argument, it should. The fundamental business of a bank is lending, just as the fundamental purpose of a furniture company is to sell furniture. Few economists believe that the government should promote the sale of bad furniture by stepping in to protect the creditors and shareholders of a poorly performing furniture company. So if banks get in the business of producing bad loans, why should the government step in to protect incompetent bank managers and their creditors and shareholders?

The economic theory behind government protection is that banks perform unique services that are difficult to replicate by any other institution. Ben Bernanke, long before he was chairman of the Federal Reserve, advanced this view most forcefully in his analysis of the Great Depression. In his view, “intermediation between some classes of borrowers and lenders requires non-trivial market-making and information-gathering services.” Further, “the disruptions of 1930–1933 reduced the effectiveness of the financial sector as a whole in performing these services.” Or, according to Bernanke, bank failures caused lending to collapse, which drove the Great Depression.15

Notice the difference between the two independent reasons to support the banking system. In the first, depositors and the payment system must be protected. This does not require any assistance to long-term creditors or shareholders of banks. In fact, it is possible to completely wipe out shareholders and long-term creditors while preserving the integrity of the payment system. The FDIC has done this many times. But in the second, bank creditors and shareholders must be protected because banks have a unique ability to lend.

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