Senator Warren grills Ben Bernanke over policy of financial failure containment

Senator Elizabeth Warren used Fed Chairman Ben Bernanke's semi-annual visit to the Senate Banking Committee as an opportunity to expose the fundamental flaws in the policy of financial failure containment and its corollary, the Geithner Doctrine.

• the policy directly leads to the creation of Too Big to Fail.  

• the policy directly leads to the Too Big to Fail banks receiving a sizable subsidy because market participants think the financial institutions will be bailed out.  No market participant believes that orderly liquidation authority under the Dodd-Frank Act will ever be imposed.

As reported by the Huffington Post,

Warren pressed the Fed chairman about whether the government would bail out the largest banks again, as it did during the financial crisis. 

"We've now understood this problem for nearly five years," she said. "So when are we gonna get rid of 'too big to fail?'" 

Regular readers know that we won't be rid of Too Big to Fail until banks are required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Ultra transparency is needed to make investors in the banks responsible for any losses on their investments.  When an investor can independently assess the risk of an investment, they can adjust both the amount and price of their exposures to reflect this risk.

So long as banks continue to be 'black boxes', there is a moral obligation to bailout the investors as they are investing based on a reliance on what the bank regulators have to say about the risk and solvency of each bank.

Warren also asked whether big banks should repay taxpayers for the billions of dollars they save in borrowing costs because of the credit market's belief that they won't be allowed to fail, repeatedly citing a recent Bloomberg study estimating that the biggest banks essentially get a government subsidy of $83 billion a year, nearly matching their annual profits....

One way for the big banks to repay taxpayers for the subsidy would be for the banks to hold their excess reserves at the Federal Reserve in an account that doesn't pay them interest.  These reserves would be used to fund the portfolio of securities the Fed purchased as a result of pursuing quantitative easing.  The earnings on these securities would flow through to the US Treasury.

he said the market was wrong to give banks any subsidy at all (in the form of lower borrowing costs), insisting that the government will in fact let banks fail. 

The 2010 Dodd-Frank financial reform law has given policymakers the tools to safely shut down big, failing banks, he claimed. 

But when repeatedly pressed by Warren, Bernanke's confidence seemed to waver. 

"The subsidy is coming because of market expectations that the government would bail out these firms if they failed," Bernanke said. "Those expectations are incorrect. We have an orderly liquidation authority. Even in the crisis, we -- uh, uh -- in the cases of AIG, for example, we wiped out the shareholders..." 

"Excuse me, though, Mr. Chairman," Warren said. "You did not wipe out the shareholders of the largest financial institutions, did you, the big banks? 

"Because we didn't have the tools," Bernanke replied. "Now we could -- now we have the tools." 

Of course, the policy of financial failure containment relies on these tools and that they work.  A really, really big "if" surrounds these tools as they apply to the Too Big to Fail.

Regular readers know that your humble blogger prefers the policy of financial failure prevention upon which our financial system is based.  It is far better to prevent a bank's failure by subjecting it to market discipline made possible by ultra transparency than to deal with a failed bank.

Later, when pressed again by Warren, Bernanke suggested that the government's tools to wind down a big bank that is failing were still a work in progress -- or at least that financial markets have not yet been convinced of their power. 

"Some of these rules take time to develop -- um, uh, the orderly liquidation authority, I think we've made progress on that," he said. "We've got the living wills -- I think we're moving in the right direction ... We do have a plan, and I think it's moving in the right direction." 

"Any idea about when we're gonna arrive in the right direction?" Warren said. 

"It's not a zero-one kind of thing," Bernanke stammered in response. "Over time we will see increasing, uh, increasing market expectations that these institutions can fail."

Until the banks are required to provide ultra transparency, we will never see increasing market expectations that these institutions can fail.

Market participants know that in the absence of ultra transparency regulators will not use the ordinary liquidation authority because it is an admission that they failed to properly oversee the banks.

Regulators will always play for time and hope that the bank can generate enough earnings to cover the hole in its balance sheet (this policy has been in effect since the 1980s and covered the savings & loans, Security Pacific and now the Too Big to Fail).

He later added, "As somebody who's spent a lot of late nights dealing with these problems, I would very much like to have confidence we can close down a large institution without causing damage to the economy."

The only way you can close down a large institution without causing damage to the economy is if there is ultra transparency.

With ultra transparency, market participants adjust their exposure to what they can afford to lose as the financial institution gets closer to needing to be liquidated.

Without this ability to adjust their exposures, there is no way to close a large institution without causing damage to the economy (this is the basis for financial contagion).

Bernanke suggested that banks would eventually lose some of the benefits of size and would shrink themselves voluntarily -- news that might surprise JPMorgan Chase CEO Jamie Dimon, who was again extolling the benefits of his bank's size even as Bernanke spoke.

If banks were required to provide ultra transparency, they would most certainly shrink themselves.  It wouldn't be voluntary, but rather as a result of market discipline as market participants raise the cost of funds to these banks to reflect their actual risk levels.