The AIG Bailout Scandal
The Federal Reserve proved to be a weak and unreliable regulator for the public interest, but blamed its weakness on inadequate laws. That excuse has now been taken away by the new financial-reform legislation, which gives the central bank more explicit legal authority to intervene and take control of troubled financial institutions. The Fed has always been able to do this—if it had the nerve to use its implicit powers in strong-armed ways. For longstanding reasons, it has lacked the will.
The Fed is now in the crosshairs and will be tested by future events. Officials may issue threats and warnings, but market players and the general public will remain skeptical until the central bank actually seizes an errant financial institution, disassembles its dangerous elements and shuts it down. That alone is needed to destroy the cynical assumption among investors, depositors and bankers that the unacknowledged doctrine of “too big to fail” still reigns. Taking this action would of course deliver a great shock to the financial system. That is why I doubt the Fed will do it.
The Congressional Oversight Panel did not address the new law and its potential effectiveness. What follows is my analysis, based on many years of observing the central bank during its turmoil of the past generation. The Fed is weak for many reasons, some revealed in the AIG story, but like any proud institution, it dares not speak candidly about its predicament. The political system is likewise still too intimidated to challenge the myth and mystery, but sharp questions have been raised since the financial crisis. If I am right, a stronger reform critique will be forthcoming when the Fed fails again to put its public obligations ahead of the banks.
One weakness is embedded in the institutional culture of the Fed—its chummy relations with the most powerful institutions and the moral confusion between public purpose and private returns. In some ways, these traits date back to the Federal Reserve’s origins in 1913, when this hybrid government agency was created, melding public and private interests. Regulated bankers participate side by side with their regulators. The central bank’s obligation to protect the “safety and soundness” of the financial system often becomes a euphemism for defending bank profitability. These qualities might conceivably be bleached away with fundamental reform of the venerable institution. Ideally, it could start with the conflicted loyalties so obvious at the powerful New York Fed.
Even in that unlikely event, the Federal Reserve will still be handicapped by the other great source of its weakness—the structural imbalance of power in which the banking giants can easily outgun their principal regulator. We saw how that happened in the AIG story when the bankers called Geithner’s bluff, after which he retreated obediently.
The awkward secret, understood by savvy Fed governors, is that the central bank has been steadily weakened by the deregulation of banking and finance over the past generation. As the Fed was deprived of various control levers with which it used to discipline the banking system, private financial power accordingly became stronger—more reckless and more concentrated at the top. As the mega-banks allied themselves with unregulated hedge funds and leverage was multiplied through off-balance-sheet gimmicks, the system became more powerful yet also more fragile, a dangerous combination. Some leaks have been plugged, but not all of them. And bankers are good at finding new ones.
Savvy bankers understand what Fed officials understand—the central bankers are trapped in a game of chicken with important banks that can call their bluff. If the Fed acts in a prompt fashion to curb or punish reckless behavior before it get dangerous, the bankers will accuse it of stifling profit and progress. Bank examiners are chastened, told to back off.
If the Fed waits too long to intervene, as it regularly did during the past twenty-five years, then it may be faced with a far more dangerous situation: given the globalization of financial markets, the system now operates with a hair-trigger response to threatening rumors or disclosures. We saw it happen in the fall of 2008. A broad panic raced around the world, freezing credit markets, collapsing financial assets and bringing down major institutions.
This discreet power struggle is never candidly acknowledged by the governing institutions (who fear it would weaken them further), but it has fed the growing instability for several decades. Fed regulators have lacked the nerve (or the hard evidence) to stop dangerous practices by banks before they reach the crisis stage. Yet once calamity appears imminent, it’s feared that taking action might provoke a wider disaster—a global “run” by investors—since other banks are engaged in similar behavior.
We might feel more sympathy for the Federal Reserve, except its leaders have actively contributed to their predicament. Paul Volcker, Fed chairman in the Carter and Reagan era, privately grumbled that removing ceilings on interest rates would weaken the central bank’s hand, but he reluctantly supported it. His successor, Alan Greenspan, led cheers for liberating the banks from government regulation. The consequences are now fully visible.
The first “too big to fail” bailout, of Continental Illinois Bank in 1984, was supervised by Volcker in circumstances that would lead to other bailouts in later years. Volcker knew the Chicago bank was drowning in bad loans, so he demanded that the board of directors fire its go-go chairman, Roger Anderson, and start writing off the bad debt. The directors called Volcker’s bluff and did the opposite. At the climax, Volcker arranged a federal rescue because he feared several other major banks were similarly vulnerable. If the Fed didn’t rescue Continental, that could touch off something worse.
“Yeah, maybe we should have nailed them,” Michael Bradfield, Volcker’s general counsel, acknowledged afterward (reported in my book Secrets of the Temple). “What are you going to say? Goddamn it, as long as Roger Anderson is chairman of your bank, we’re not going to lend any money at the discount window? You can say it and it’s pretty intimidating, but the directors can call your bluff…. as a practical matter, you can’t. The consequences of refusing to supply liquidity support to a bank are too severe.”
In other words, the AIG case was not only about weak regulators. Geithner was weak and easily spun around by the bankers, but Volcker was a monumentally tough regulator, and he made similar decisions when his bluff was called. That comparison is my evidence for the structural causes beneath politics and personalities. Those deeper causes have not been fixed.
Lots of ordinary citizens have figured this out. If some banks are too big to fail, then government should compel them to become smaller banks. The harsh reality is that our bloated financial sector is too large for the economy it serves, its power too concentrated at the top. Neither the president nor either political party is yet ready to face the imperative of breaking up the mega-banks. Until they do, the system will remain unstable and prone to excesses, maybe worse.
Meanwhile, the Federal Reserve’s dilemma has been made much larger. It has been given broad discretion to enforce many structural changes on the financial system. But discretion can be fatal for regulators, as AIG illustrated. It asks Fed leaders to get tough with their principal clients, when Congress didn’t have the nerve to do the same. Congress needs to write hard-nosed laws with concrete prohibitions and specific enforcement triggers, not wishful requests. If the Fed again fails to act, as I fear, another crisis becomes more likely. If that occurs, the Federal Reserve will be the next big subject for reform.